Social Security’s Coming Crash: The Certain End of Entitlement

This article appeared in the November 2009 issue of Chronicles.

The welfare state was born in Otto von Bismarck'sGermany, a ploy of the famed Iron Chancellor designedto counter the electoral appeal of the rival SocialDemocrats. Thus, social security was created in 1889 andeventually spread, under several guises, to many nations.Here, the Old Age, Survivors, and Disability Insuranceprogram (Social Security) was approved in 1935, an earlyvictory for Franklin Delano Roosevelt as he rapidly anddramatically expanded government control over the economy.For FDR, Social Security's most important benefitwas political: He recognized that once the American peoplegot hooked on government benefits, they would nevergo back.

He was right.

Although Social Security has long been viewed as thethird rail of American politics—touch it and die—it reallyis better seen as a symbol of America's entitlement culture.The United States lags behind Europe but neverthelesshas constructed an expensive and expansive welfarestate. Virtually all spending programs go up each year,regardless of which party controls Washington, and themost outlandish increases have been concentrated in thebig three social-welfare systems: Social Security, Medicare,and Medicaid.

The challenge of paying for the welfare state has grownover the last year.

U.S. GDP is about $14 trillion. One year of economicoutput already is committed to paying off the nationaldebt, which is now above $12 trillion and climbing fast.

Washington is running a deficit of some two trilliondollars this year and is expected to pile up another tentrillion in debt over the next decade. In fact, these estimatesare low: Fannie Mae, Freddie Mac, the FDIC, thePension Benefit Guaranty Corporation, the Federal HousingAdministration, and who knows what else continue torun up big losses and will need more bailouts. So countanother year's production toward the federal debt.

Then there is all of the funny money used to fund theestimated $13 trillion in bailouts doled out over the lastyear. Some of the cash, such as the so-called TARP money(the financial-institutions bailout that somehow wasused to nationalize the auto industry), was appropriatedby Congress. But between the Treasury Department andFederal Reserve there have also been loans, guarantees,and money creation. It is hard to know what it ultimatelywill mean in financial terms, but another year of America'seconomic life will certainly be lost.

Finally, there are Social Security and Medicare. Together,they have about $107 trillion in "unfunded liabilities."In real-people-speak, that is the difference betweenpromised benefits and expected revenues. That amountsto about eight years of America's economic productionand twice the world's annual GDP.

Social Security and Medicare are disastrously unbalancedfor three reasons. First, "contributions" to SocialSecurity and Medicare are insufficient to provide thepromised benefits. Indeed, Social Security operates as aclassic Ponzi scheme, with new contributions used to payoff earlier "investors."

Second, life expectancy is up, and fertility rates aredown. The population is aging, with a larger number ofelderly living longer. This is good news for people but badnews for Uncle Sam.

Third, medical outlays are increasing rapidly. In recentdecades Medicare outlays have risen three percent annuallyabove the increase in per capita GDP. Since the elderlyconsume far more healthcare services than youngerAmericans do, this factor compounds the impact of demography.

Even before last fall's financial crash, then-comptrollergeneral David M. Walker warned, "The only thing theUnited States is able to do a little after 2040 is pay intereston massive and growing federal debt. The model blowsup in the mid-2040s. What does that mean? Argentina."

Insolvency is not the only problem facing Social Security.The system is essentially stealing from those nowentering the workforce.

The rate of return was good for early recipients becausethey had low payroll tax rates and paid in only for a fewyears. The very first recipient, Miss Ida May Fuller, contributed(herself and through her employer) just $49.50in payroll taxes before she retired at age 65. She livedto 100 and collected $22,888.92 in benefits. Althoughnot all early recipients made out so handsomely, manybeneficiaries received back their lifetime Social Security"contribution" in months rather than years.

But as the number of workers per retiree has fallen—from 42-to-1 in 1940 to about 3-to-1 today, on the way tobelow 2-to-1—the tax rate has risen dramatically. Manypeople of modest means pay more in Social Security deductionsthan they pay in income taxes. Increasing numbersof young workers now will lose money, assumingthere is money available to pay for their benefits whenthey retire.

Almost every proposed "reform" scheme would furtherdrive down the system's return, increasing taxes while cuttingbenefits. The program has become the worst sort offool's bargain—at least for everyone but the politicians whotake credit for handing out money to a pliant population.

Last fall's stock-market collapse demonstrates thatprivate markets offer no guarantees. But that uncertaintyshould be contrasted with the certain bad deal fromthe federal government. Moreover, the return on privateinvestment has remained well above the levels for SocialSecurity even when measured against major stock-marketdownturns. The rate of return was over three percent annually,handily beating Social Security's return these days,for even the worst 20-year period in American history,which encompasses the Great Depression.

Furthermore, Social Security's nominal rate of returnneeds to be discounted by its negative impact onthe economy. The program reduces both the amount ofmoney available for workers to save and their incentive tosave. By diminishing the resources available for economicinvestment, Social Security reduces both GDP and realwages in future years. Estimates of that loss range fromfive to ten percent. Integrating that impact into currentrates of return makes today's average return negative.

Advocates of Social Security claim that it benefits lowincomerecipients, but Social Security actually discriminatesagainst women, minorities, and anyone else with ashorter life expectancy. Moreover, the program was developedfor two-parent, single-earner households. Underthe current rules, two-earner couples, singles, and youngdivorcées—an ever-larger share of the population—are ata disadvantage.

Social Security is more than just a financial bad deal.The program undermines personal responsibility bydiscouraging saving and encouraging early retirement.Equally damaging, Social Security shifts the duty of caringfor our elders to the government. As a result, manyAmericans end up dependent—a substantial number almostwholly dependent—on government.

Social Security discourages private saving in two ways.First, it takes money that otherwise would be invested ineconomically productive private activities and dumps itinto the Treasury (the "trust fund" is a political fraud) forredistribution by Washington. This year about $560 billionis disappearing into Uncle Sam's porous pocket.

Second, creating a government retirement systemmakes private saving less necessary. Social Security reducesinvestment, economic productivity, job creation,and overall growth. Harvard's Martin Feldstein figuresthat Social Security "benefits replace more than 80 percentof peak preretirement after-tax income. Commonsense and casual observation suggest that individualswho can expect such a high replacement rate will do littlesaving for their retirement." The financial crisis has exacerbatedthis tendency: More than one third of thosebetween 45 and 54 have stopped contributing to privateretirement accounts.

Social Security almost certainly has had a deeper socialimpact. The program creates a powerful incentive forearlier retirement. Obviously, people may retire wheneverthey desire and can afford to do so. But it is foolishfor Washington to push people into retirement. TheNational Center for Policy Analysis reports that since theprogram's beginning the percentage of men over 65 whowork has dropped by half. The work-participation ratefell as Social Security covered more men and deliveredgreater benefits.

The program also has transformed the workplace. Thepayroll tax directly penalizes employment, discouragingjob creation. For the average family, writes Feldstein, SocialSecurity "raises the total marginal tax rate to morethan 40 percent and substantially exacerbates the distortionsand waste caused by the income tax." The levy alsoinfluences choices on how many hours to work and how tostructure compensation—emphasizing untaxed fringe andnonpecuniary benefits. This is a particularly perverse incentivefor a government pension system funded throughemployment. Penalizing workers means that people willwork and save less, and retire sooner. In turn, there willbe fewer workers to support each retiree. This reductionin the number of workers per beneficiary is the principalreason Social Security is rapidly approaching collapse.

The change wrought by Social Security is not just economicbut philosophical. Children now see the governmentrather than the family as having primary responsibilityfor providing retirement security. And retireesbelieve the government "owes" them their Social Securitybenefits. (In fact, the Supreme Court has ruled that UncleSam has no legal obligation to pay.)

Intergenerational ties are often difficult to maintain,but they are among the strongest bonds of community.The ultimate result of social welfare is, as Chancellor Bismarckintended, to encourage widespread dependencyon the state. America's Founding Fathers feared this possibility.As Thomas Jefferson put it, "Dependence begetssubservience and venality."

The imminent collapse of Social Security adds anotherelement to the studied campaign to make people dependent.Never mind that successive presidents and Congresseshave promised to protect the elderly. Never mind thatpolicymakers have discouraged Americans from preparingfor their own retirement. Never mind traditional notions ofcommitment, trust, and honor. Uncle Sam will leave everyonehigh and dry without even a glance backward.

We must confront the welfare state and the entitlementmentality that underlies it. To do that, we must transformSocial Security.

The longer we wait, the more difficult it becomes toclose the gap. Last year was particularly bad because ofthe economic crunch; the total unfunded liability for SocialSecurity and Medicare grew by nearly six billion dollars.Reforms are hardest to apply to those who havealready retired: "Delaying action until the baby boom is infull retirement insures that the next generation will bearthe burden of current inaction," argue Andrew J. Rettenmaierand Thomas R. Saving of the Private EnterpriseResearch Center at Texas A&M University.

And that cost will be huge. David M. Walker observesthat

Failure to take steps to address our large and structurallong-range fiscal imbalance, which is driven inlarge part by projected increases in Medicare, Medicaid,and Social Security spending, will ultimatelyhave significant adverse consequences for our futureeconomy and the quality of life of our children,grandchildren, and future generations of Americans.As a result, the federal government needs to engagein a fundamental review, reassessment, and reprioritizationthat will ultimately have to span all majorspending programs and tax policies.

Perhaps economic reality will finally force Congressto act. For Social Security has become the reverse thirdrail of government finance: Don't touch it, and America'seconomy dies.