Friday, October 29, 2004

There is no Transition Cost

This is an excellent post, again by Arnold Kling, on why there is no transition cost if social security is switched from a pay-as-you-go system to a funded system.
The transition cost is a myth. In economic terms, the transition cost is zero.

From an economic perspective, the transition exchanges an off-balance sheet obligation of the government for an equal-value on-balance sheet obligation. It makes government accounting more honest, without changing the underlying debt structure.

When your Social Security taxes are reduced by $1000, the government will reduce its obligations to pay you Social Security by an equivalent amount. That is what partial privatization means -- you have to take that $1000 and invest it yourself, because the government is reducing its future payments to you.


One way to eliminate the "transition cost" to partial privatization would be to first undertake a transition to better accounting. If the government were to put future Social Security obligations on its balance sheet as debt, then the accounting would be accurate. To borrow a locution from Warren Buffet, if promises to make Social Security payments are not a financial obligation of the government, then what are they? And if a financial obligation of the government is not debt, than what is it?

If unfunded liabilities to make future Social Security payments were counted as debt, then partial privatization would be nothing but a debt swap. The government would increase ordinary debt and reduce unfunded-liability debt by an equal amount. The transition cost would be zero.
This basic economic principal is not understood by many people, including David Warsh, writer of Economic Principals.

UpdateReader SG sends in this excellent post argueing that promises to pay social security are not a government's financial obligations because governments don't keep their promises, and in fact renege on their promises all the time. Several times on this blog I've wondered what the fiscal analog of a central bank might be, and I think that one good contender would be for government to switch from cash accounting to regular accounting. Certainly, have an enormous and public "Accounts Payable" for social security and medicare would focus the mind on these costs, and the balancing "Accounts Receivable" would focus the mind on the taxes neccessary to meet those obligations.


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