What Washington Is Missing

The biggest challenge for Social Security is the stubbornness of Washington where our leaders are focused on yesterday's news, and promote ideas which are yesterday's answers. The experts believe that the problem is demographic in nature, ie too many retirees for each worker. While demographics may be a problem, it isn't the imminent problem.

The pressing problem is stagnant wages. Social Security depends upon wages from the private sector to pay benefits. While public sector jobs may contribute to the system, these jobs are funded again by private sector wages in the form of income taxes. Over the past 10 years, the problem of demographics has been replaced by a much larger problem of economics: jobs, wages, and productivity.

The following article is important to read. Here is its connection to Social Security. There are fewer jobs to pay into Social Security. The job mix is shifting to lower paying work. Finally, much of the wage growth is in benefits which are not subject to FICA tax. In conclusion : you can't increase wage growth with higher taxes.

http://www.investors.com/NewsAndAnalysis/Article/573982/201106020800/10-Year-Real-Wage-Growth-Worse-Than-During-Depression.aspx is a worthwhile article to see what is happening our labor markets.

Here are some highlights:

• There has been a net loss of 2.7 million private nonfarm jobs since March 2001. (Government payrolls rose by 1.2 million over that span.)




• The problem is worse than lost jobs, as job losses have been concentrated in higher-paying goods-producing sector, including construction and manufacturing, which has shed 26% of its workers. Job growth has been in typically lower-paying service industries have kept growing their payrolls: social assistance (41%), nursing homes (21%), leisure and hospitality (10%).




• Globalization of production has fed a "the substitution of capital for labor" amid a push for productivity and competitiveness.




• The increase in nonwage compensation — fueled by the growth of tax-free health care spending — which has eroded real wage gains.
  

Higher Taxes And Lower Benefits Will Only Make Social Security Worse

Last summer, Congressional Budget Office scored 30 potential solutions for Social Security for the effectiveness of each in dealing with the financial imbalances in the system. Every solution was either a tax increase or a benefit cut. More recently, the President’s Financial Commission on Fiscal Responsibility outlined yet more solutions which consisted of benefit cuts and tax increases. It is a frightening statement on how little our leaders understand the problem.

The solvency of the Trust Fund is not the primary problem in Social Security. The question of solvency is the unavoidable outcome of a deeper problem within the system, return on contribution(“ROC”). It is terrible, particularly for younger workers. If so raising taxes and cutting benefits will only make the core problem worse and the whole system less stable because while these solutions will make the Trust Fund last longer, it also discourages people from participating.

Social Security is unfortunately a pay-as-you-go system for which the Trust Fund provides very little economic support. According to the Social Security Administration, the OASI Trust earned only 118 billion dollars in 2009 while distributing 564 billion dollars in payments . Moreover, the role of the Trust Fund in providing for Social Security benefits is likely to drop going forward . So the solutions in Washington largely provide 15% of the solution and put the rest of the system at risk.

The problem is return on contribution. When the ROC drops, so does the willingness of people and business to participate. They either evade or avoid the system. In a recent study, it was estimated that two trillion dollars of the economy is underground hiding from the tax man . The hidden economy costs Social Security as much as 250 billion dollars last year. The larger problem is that the ROC encourages business to allocate labor earnings away from wages into benefits which are not subject to FICA tax. Data from the Labor Department shows that wages are only 70% of employee compensation. The remaining wages are paid in benefits which are not subject to FICA taxes.

How bad are the returns in Social Security today? Last summer, the government provided a periodic moneys-worth study of the Social Security system, which compares a dollar of contribution with the present value of future benefits. A moneys-worth ratio of 1 means that you are getting back exactly what you put into the system. In the report, the government predicts that some workers will get back as little as .50 cents on the dollar . The report paints, however, a rosy picture of the real returns from the system by using assumptions which artificially inflate the ROC. The report assumes that all workers given a choice would invest the money as poorly as the Trust Fund does. Social Security for younger workers isn’t terribly different than spending quarters to buy dimes.

Washington’s solution to this problem is to get younger workers to spend quarters to buy nickels.

The Crisis Is Social Security Is Bigger And Closer Than You Think

The Social Security Administration shortened its timeline for the depletion of the Social Security Trust Fund. Now the Social Security Administration projects that the Trust Fund will be exhausted in 2036. This change in timeline means that if you are 43, you are scheduled to retire the year that the Trust Fund hits zero.

This story shouldn’t be ignored by anyone of any age because Washington’s record in financial forecasting is astoundingly bad. The government was wrong about Freddie and Fannie. The government was wrong about the housing bubble. The government was wrong about derivative exposure of the banks. The government wasn’t just wrong it was wrong on scales never seen in human history. Can you afford for them to be wrong again?

There are two huge differences between failing to see the dangers of the banking crisis and failing to foresee the collapse of Social Security. First, the government served as a backstop in the banking crisis. There isn’t anything to backstop a crisis in Social Security. Second, if the government had allowed banks to fail during the banking crisis, the bankers would have adapted, and become something new. Social Security primarily serves the elderly and disabled. This audience consists of people who are not equally suited to adapt to change. If a crisis erupts in Social Security, the consequences will be severe, and will have human consequences not seen in this country since the 1930s.

The problem is much bigger and closer than Washington understands. The projections of how long the Trust Fund will last are based on a number of economic assumptions. If one assumption is wrong, then the projection will be wrong. For example, if real interest rates are 2.9%, the Trustees project that the fund will last until 2036. If real interest rates fall to 2.1%, the Trustees project that the fund will last until 2034. The fact is that the real interest rate is closer 1.5%, and will be for some time as the Trust Fund replaces maturing high-yield debt with debt based on today’s interest rate structure. So prepare for next year’s exhaustion point to be less than 2036.

The problem is much bigger as well. Washington is looking at the wrong metric as usual. Washington and the talking heads in the mainstream media believe that the key figure is the support ratio, the number of workers to retirees. It is dangerous to think of this relationship as a useful number because workers do more than support retirees. Workers also support the interest cost of the government. A better picture of the problem is looking at debt burden + retiree cost / worker. The situation is much worse in that light.

People have talked about the crisis in Social Security for so long that most people are immune to the idea that there will be a crisis. I want to change the discussion from whether a crisis will occur to how it will take shape when it occurs. The crisis will form out of the deficit, and the interest burden to support it. Interest cost currently consumes 30% of our tax base, and that percentage is growing. Interest is not negotiable, and it will over time set-off a national debate about how taxes are raised and how money is spent. The Teaparty is just the beginning of that discussion.

Many people look at Social Security as independent of the deficit because it is funded by payroll taxes not income taxes. The problem is that both taxes draw on the same tax base, so they are somewhat mutually exclusive. They are like two straws drinking from the same soda. Any dollar raised in payroll taxes is a dollar that cannot be raised in the form of income taxes. In this sense, Social Security will become a major target when interest cost force a discussion about how the taxes will be spent. To pay down the deficit, the working generation need only vote to increase income taxes and decrease payroll taxes. When that happens, Social Security will simply be re-written on very different terms.

It will have to be re-written because Social Security will have to depend upon the Trust Fund once the payroll taxes are cut. While 2.5 trillion may sound like a lot of money, it is basically economic parsley when compared to outgo of the system. Without payroll taxes, the Trust Fund would last less than 4 years. When the crisis forms, the economic support for the retired really will come down to how much payroll taxes the working generation is willing to pay.

The support for Social Security within the working generation may be very modest. It is virtually impossible to believe that the working generation will not resent the obligation to take care of both the deficit and the retirees who largely created it as younger voters. For years, baby boomers have talked about the burden that they are putting on their children. The fact is that it is a burden that their children can largely shake-off simply by diverting payroll taxes to pay down the deficit. It is naive to believe that politicians will not serve that audience.

You will start seeing this politician much sooner than you think. According to the US Census bureau, 2010 was the first year that a majority of voting aged Americans can expect to less than what was promised. 2012 will be the first year where a majority of registered voters can expect to get less than what was promised. That trend continues until a majority of registered and active voters can expect to get less than what was promised. To believe that Social Security will survive in its current state, one has to believe in a majority of people will vote against their own self interest.

Politicians will emerge to play on this block. They will say: Interest is the cost of government that the retired generation wanted but was unwilling to pay for. They will say: the retirees padded their retirement accounts (ie Social Security) while putting the rest of the government on your credit card. They will say those retirees had pensions that you don’t. They had healthcare costs that weren’t burdensome. They had 4 years of college for what you pay per class. And they will get elected on that message.

Of course, I could be wrong, and Washington might be right. Maybe deficits don’t matter. Maybe foreigners will continue to lend us dollars knowing that they will be repaid in pennies. It all comes back to the real question : can you afford for Washington to be wrong again?

Social Security Number Watch

Be very careful when you are looking at numbers about Social Security.

Numbers about Social Security do not lie, but they can mislead not only the public but policy makers as well. The numbers watched by the experts in Washington suggest that Social Security is slowly moving to crisis. The numbers have lulled even the harshest critics of the system into believing that the system is many years from crisis. The problem is in the numbers : we are looking at the wrong numbers.

This article isn’t for policy wonks. It is intended for average Americans who get pounded with useless statistics about the system. This is a typical quote that a reader will see when researching Social Security : “When Social Security started, there were 16 or 17 workers for every retiree. When the baby boom finally finishes retiring, there will be 2 workers for every retiree.”

It sounds scary, but it is completely uninformative. The statistic in this case is the Support Ratio[1]. It doesn’t accurately track what it is suppose to track, and authors subsequently quote bad data out of context. In the process, the statistic goes from simply bad economic theory to dangerous public policy.

First, the number of workers includes government workers who have been purchased with debt, or future tax revenues. This debt inflates the number of workers today by pulling future jobs into the today's numbers. If as CBO has warned, the government is unable to place debt at reasonable prices, these jobs will disappear. Worse, if the productivity of the public-sector jobs doesn't create sufficient wealth to pay off this debt, the debt becomes a drag on future jobs.

Second, the number does not factor in the impact of the Trust Fund[2]. The Trust was designed to hold excess cash in the system, so that the Trust Fund could serve as an addition worker as the Baby Boomers started to retire. Hence some of the workers from the 1990s were really working to support 2010 beneficiaries – the first year that outgo of the system exceeded payroll tax contributions. In 2009, the Trust Fund generated about 110 billion dollars of interest income. That is about 16% of the total income of the system. So the workers per retiree should have been roughly .5 workers higher.

Even if one had an accurate Support Ratio, the number isn't very informative because it does not factor in productivity. As productivity increases, it takes fewer workers to support a retiree. When Social Security started, we had something like 25% of our workforce in argricultural production. Today it is something like 3%. Telling someone that there are too few workers without knowing what their productivity is, is just like telling someone that they are over-eating without considering their exercise regime. That is where the data goes from wrong to pointless.

Experts use this statistic far out of context, as you can see in the example above. In the context above, the author assumes that workers are the same today as in 1955. The assumption is horribly wrong. Today’s worker contributes at a higher rate and against a larger cap. In 1955, the maximum contribution was an inflation adjusted $168. Today it is more than $13,000. In other words there are workers in 2011 who effectively are the same as 77 workers from 1955.

Like the workers who are counted like beans, the beneficiaries are not the same today as they were in 1955. According to JustFacts.Com, “Benefits have not remained constant. If they had, SS would now be collecting roughly three times more in taxes than it is paying in benefits.” I haven’t seen their data, but it is not unreasonable. Beneficiaries are living longer and may well be retiring earlier. Comparing the number of beneficiaries over time when pay-outs are changing is simply pointless.

A reader might arrive at this point in the article feeling relieved that the Support Ratio suggests that the problem is smaller than the raw data suggests. And that belief would be correct if workers did nothing but support retirees. The fact is that they do substantially more than support retirees. Workers through wage taxes also support the budget deficit. The budget deficit is growing and so is the interest cost to support it. Today’s worker carries about $75,000 in look through debt from the government. Assuming that workers today are in the same position to provide financial support for retirees as they were 40 years ago, or even 5 years ago, is where authors cross the line from bad economics into dangerous public policy.

In summary, there very well may be a shortage of workers to provide benefits for all of the Baby Boomers. My guess is that there is a dramatic shortage but I don't have any data to support that belief. The actual data that you need to see is compensation slack - which would measure the ability of workers to support a retiree. If you had that data, I suspect that the slack has dropped radically and you would see that the crisis is now, not some stardate in the distant future.

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[1] The SUPPORT RATIO, which measures the number of beneficiaries to number of retirees. Data Source Social Security Administration

http://www.ssa.gov/OACT/TR/2010/lr4b2.html

[2] There are some who question the existence of the Trust Fund. Here is why I discount their view. The government holds a number of hard assets such as oil, land, and gold. Beyond that, the government has future revenue streams based on 16.6 trillion dollars in retirement assets which are tax deferred. Beyond that, the government has the ultimate power of taxation, printing money. As long as the citizens grant the power to print money to the government, US Treasury debt will represent the safest investment in the country.

How Corporate Darwinism Caused The Credit Crisis

There are numerous forces to blame for the financial crisis. Some blame the government. Others blame greed. Still others blame slumbering regulators. While everyone has a point, the real cause of the financial crisis is corporate Darwinism. Over 20 years of boom times, natural selection picked bankers, and bureaucrats, and elected officials who were great for the boom, but completely ill-suited to respond or even understand a credit crisis, particularly one of the magnitude which our country experienced in 2008.

The principle of Darwinism is pretty simple. Organisms adapt to changes in their surroundings by nature selecting traits that are suitable to survival. Whether it is a finch in the Galápagos Islands or a moth in London, spices that cannot adapt to change will die off. This process is normally associated with animals, but it affects all organisms including abstract ones like corporations.

The process works within a corporation surprisingly similar to that which operates in nature. The only difference between evolution in nature and evolution in a corporation is the speed of the transformations. Corporate Darwinism moves much faster because humans can learn traits where as a bird in the Galapagos requires generations to grow a longer beak.

Corporate Darwinism selects traits by promotion. Once a trait is promoted, the corporation seeks to replicate that trait across the organization. The best example of this is when a manager is hired from the outside, and the first thing he or she does is hire people from his old organization. When someone is promoted internally, everyone around that person tries to emulate the traits which resulted in promotion. Promoted traits literally breed into a corporate culture.

To understand how the process works in corporations you need only study the reward system. If the system rewards long hours, you will find people at the company who are willing to sacrifice personal lifestyle for the good of the company. It isn’t that they are more selfless, but anyone unwilling to work within the system of rewards normally leaves or is pushed out.

I worked in and around banking for 20 years. During that time, I saw only one recurring system of reward, the willingness to take risk. I saw bright people promoted. I saw charming people promoted. I saw tall and short people promoted. The common thread in all promotions was the willingness to push buttons without regard to possible consequences. This selection process started at a very low level, and persisted through-out the organization. It isn’t that they were not bright or talented, but all of them had one thing in common, risk tolerance.

During my time in banking, I also knew very talented people who weighted the cost and benefit of their decisions. These people were systemically removed from the pool because the trait wasn’t valued. In the absence of a reward, people leave. Probably the best manager of people with which I worked was at Citibank. Eric Snead was a very talented manager who brought all of the skills needed for management. He recognized talent. He was very good at scoping work, measuring ability of people on his team, and motivating them to get the task done. He unfortunately had sensible view of risk, and his management did everything that they could to get him to leave, which he eventually did.

Over time, Corporate Darwinism selected risk tolerance as a survival trait in banking. That trait became more significant to survival during the economic boom because people at some level are promoted because they produced earnings streams, or sales, or some measure of profitability. The boom made stupid transactions seem wise, and foolish risks were rewarded. In boom times, the more risk tolerant the person the better his level of success. This is what Chuck Prince meant, when he said that you have to dance as long as they play the music. The most important thing to understand about booms and Darwinism is the statistically likelihood of the system promoting someone with a sensible risk perspective becomes lower and lower.

So the boom introduced a bias to people who discounted risk. At the same time, one of the causes of the boom was changing the selection process, cheap money. Over the past 20 years, the response of the Federal Reserve to every economic crisis was increased liquidity. That is a fancy way to say give bankers very cheap borrowing costs. Over time, Darwinism selected the managers who treated capital as though it were free and endless.

So by 2007, it should surprise no one that Darwinism had selected companies like Bears Sterns for survival. It was levered 30 to 1. The economy had made its corporate culture wildly successful. It made billions packaging and selling loans. When one bet was rewarded, they took on more risk in the next one. This is how you expand from prime loans to alt-A to sub-prime. Bankers call this universe expansion. The bankers didn't make the era. The era made the bankers.

Unfortunately, the traits which led to success in the boom era were exactly what made them unable to survive in 2008. Darwinism had selected decision makers who had virtually no sensitivity to risk and people who were oblivious to the cost of capital. The survivors of 20 years of success were simply unable to grasp bets losing. The head of Bear Sterns appeared on CNBC to assure the investors days before it was to be forced into bankruptcy. Many of the companies who caused the credit crisis could have tapped the capital markets for equity within months of complete failure. Those who did pursue additional equity only took very little. Darwinism had selected bankers and regulators who never considered that a credit crunch was even possible. When it happened, they were just deer staring at headlights of the oncoming traffic.

There is one other factor to consider. In 1998, the United States government repealed Glass-Stegal which had placed strict limits on how much risk a bank could assume. Much more than the legal aspect, the repeal of this regulation altered the pool of applicants on which the bank could draw. The change introduced a pool of candidates that were much more willing to take risks, ones that were backed by the taxpayer.

My guess is that many corporate cultures outside of banking encourage risk. They do so however with their own capital. So the market place manages these entities. If the maker of widgets takes on poorly placed risk, the market punishes the widget maker. The problem with banks is that if the banker takes on poorly placed risk, the market punishes the taxpayer.

The short version here is that animals called bankers grew in size and proportion in a boom environment. Nature selected those who were the fittest for that environment. In 2008, the environment changed and the animals were like dinosaurs looking at the glaciers.

How Lower Interest Rates Are Stalling The Recovery

If Neville Chamberlain were alive today, he would be an economist instead of a diplomat. He would be creating jobs instead of peace. He would champion the Federal Reserve line that we need low interest rates to stimulate the economy. He would get off the plane with the Beige Book to proclaim: “We have jobs in our time”.

The common economic analysis says that low interest rates spur investment which creates the jobs that are needed to drive the economy. Unfortunately, this economic myopia works only in the world of academia where it is possible to hold the world ceteris paribus and keep the forces of unintended consequences in the footnotes.

The basic flaw in this economic model is that it assumes that all investment is good and that resources put to work were idle. The model works well when an unemployed person borrows to open a business which is profitable enough to repay the loan. The model works less well as the quality of the investment erodes, or the resources employed were drawn away from productive uses. For example, it is possible that lower interest rates will encourage a good baker to become a bad house flipper. Does that help the economy?

What economists need to explain is how the economic transfers actually make the economy better. Lower interest rates transfer economic activity from the future to the present. It transfers wealth from lenders to borrowers. It transfers demand from unleveraged purchases to leveraged purchases. But how does all of this economic activity help the economy?

Interest is the cost of money over time and risk. Lowering the cost of money today means that you will push demand forward, getting people to buy things today that they would have bought in the future. This demand comes from somewhere. It is shifted from other current demand, or it is brought forward from the future to the present. When I buy a $30,000 car today on leverage, it is $30,000 of purchases of other things that I am not making in the future. Debt is not spurring the economy. It is borrowing prosperity from the future.

It is the purchases ‘not made’ that economists never factor into a ceteris paribus model. Economists focus solely on the borrower who invests the money, but they forget that for every dollar of interest saved someone has lost a dollar of payment. The bank is not a lender, but rather a conduit to the lender which may be an 85 year-old retiree. When the Federal Reserve lowers interest rates by 90%, it is effectively cutting the pay of the 85 year-old retiree. It is cutting the pay of businesses which no longer enjoy the patronage of the 85 year-old retiree.

This activity will help the economy only to the extent that the borrower spends the money more wisely than the 85 year-old retiree would. This is a pretty dubious assumption given that the interest rates are a function of risk. So lowering interest rates encourages marginal borrowers to open businesses which would not exist under a normal interest rate structure. In the case where lower interest rates encourage a good baker to become a bad house flipper, the economy is going to be hurt.

One should ask what will happen to these businesses once the interest rate structure normalizes. As the cost of funds rises, will these new businesses survive? Some will not, and you have to ask how does it help the economy to have someone leave a productive job to start an unproductive business that ends in bankruptcy?

It is economically unreasonable, if not counter-intuitive, to suggest that desensitizing the users of capital from the cost will lead to a better economy. To suggest that the lowering the cost of money is good for the economy is no more reasonable than saying that lowering the cost of bread will help the economy. In this case, the buyers of bread win and the bakers of bread lose as people buy more bread. The bakers of muffins lose as more people eat bread than muffins. There are winners and losers, but the problem with the logic isn’t in the winners and losers – it is in the bread crumbs. If you lower the cost of bread people, both consumers and producers, will leave more crumbs.

To illustrate the ‘bread crumbs’ of capital that are lost to lower interest rates, drive to any new housing development. There are 5 or 6 where I live. While these developments serve different markets and different pricing points, they all have one thing in common – no workers and no occupants. If you call the realtors you get the same story – we are waiting for the market to turn. It is only possible to hold these economic assets inactive because of the internal cost of funds at the bank.

The owners of capital have no reason to pick-up the ‘bread-crumbs’ when interest rates are .25%. People will let the penny jar grow. What is the point of putting them in a bank when the rate is .07%?

One of the inescapable ends of lowering interest rates the way is a rising foreclosure rate. Levered assets will flow over time the lowest cost of funds just as water runs down hill. If the marginal homeowner pays 6% and the bank pays .25%, the cost of owning the home by the bank is fractional compared to that of the homeowner. The bank will hold real estate longer, and be less willing to renegotiate existing loans. There is nothing in that outcome that helps the economy.

The whole point of lowering interest rates isn’t to improve the economy. It is to give the voting public a nearterm feel-good number that makes them think that the economy is turning around. The fact is that all of what we are doing is making the crisis worse and last longer than it should.

Why Should The Elderly Bear The Burden For The Financial Crisis

This is an open letter to the AARP.

AARP
601 E Street N.W.
Washington, DC 20049

Dear AARP,

I would like to know more about your organization, and give you a chance to reply to what in my mind seems like an irreconcilable contradiction between the stated goals of your organization and what appears to be a complete indifference to the welfare of your members.

Your members are largely retired, and in some part dependent upon generating a fixed return from their life’s savings. This income is their paycheck, and provides in many cases necessities of life. That paycheck has been cut by more than 90% by the Federal Reserve which has forced interest rates down to help stabilize the global financial system.

In the last two years your members have watched their money market rates drop from over 5% to .07%. The percentages don’t tell the story of your members, though. The 85 year-old retiree who saved $30,000 through hard work has watched his paycheck drop from $1,500 to $21 by government fiat. Every year this person gets to loses $1,479 of things that they don't eat, children they don't see, and basics that they don't have. And for what: so that bankers can take millions in bonuses to their homes in the Hamptons.

Your organization seems OK with this pay cut to help the country. So I have to ask whether you took a 90% pay cut to help the country? Ben Bernanke didn’t take a pay cut, and neither did Geithner. But you are letting the government force a 90% pay cut on your members, who are now forced to rethink the basic needs of life. Frankly I have a difficult time reconciling the amount you are paid with the nothing that you are doing.

While every American is ready to do his part to fix our country, I am pretty sure that asking $1,479 per year from someone bordering on the poverty level is more than his fair share. Fairness is of course always debatable. Maybe you think that is fair. Is it fair to ask the elderly to bear the brunt of the burden for solving this crisis? Is it fair to ask why AARP hasn’t asked this question? I will tell you that it is fair to ask why AARP has been completely silent on the issue.

What isn’t debatable is the fact that the members of AARP had statistically the least to do with the causes of the crisis. Statistically, AARP members own their homes with no ARM leverage. They don’t flip homes. They didn’t originate, package, rate, or sell toxic assets to institutional investors. Punishing the elderly for the casino lifestyle led by others is no more sensible than kicking the dog when your kid brings home bad grades.

Your silence on the Bernanke policies is shameful and reprehensible. What should bother you most is that he is not even an elected official. He is a bureaucrat who has decided one group of people should benefit at the expense of the dues paying members of the AARP. And your organization does nothing to protect those who pay dues to you.

I am writing you so that I can be wrong. I would welcome hearing that you have engaged your lobbying team to protect your members. I would welcome hearing that you took a pay cut so that you could share in the pain of your community. I want to be wrong, and look forward to getting a letter from you explaining how I am wrong. Here is where I am not wrong - what our country is doing to people living on a fixed income is wrong, and no one seems to be doing anything about it.