I worked with adult illiterates for about 10 years in the 90's while living in Louisiana. The textbook angle is a new one to me. I had previously blamed it all on schools and grant money. Now I will blame it on "all of the above." I have moved on and the group I worked with, all volunteers, have moved up in the world -- but they are still teaching adult illiterates and the high schools are still graduating many who read at a third grade level. No wonder we have people who believe every thing they hear on TV. Thank goodness they can't read the newspapers -- it might be even worse.

Privatizers who laud the Chilean system never mention that it has yet to deliver on its promise to reduce government spending. More than 20 years after the system was created, the government is still pouring in money. Why? Because, as a Federal Reserve study puts it, the Chilean government must "provide subsidies for workers failing to accumulate enough capital to provide a minimum pension." In other words, privatization would have condemned many retirees to dire poverty, and the government stepped back in to save them.

The "Federal Reserve study" to which Krugman refers is "State Capacity and Pensions" by Stephen J. Kay of the research department of the Federal Reserve Bank of Atlanta. It is hardly a "Federal Reserve study," but rather a March 2003 symposium paper presented by Kay, about which Kay himself said "The ideas expressed in this paper are those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Atlanta or the Federal Reserve System." Krugman not only exaggerated the provenance of the research -- he also misrepresented what it said. Here's the context from which Krugman's quotation comes:

Chile’s transition costs averaged 6.1% of GDP in the 1980s, 4.8% of GDP in the 1990s, and are expected to average 4.3% from 1999 through 2037 (Devesa-Carpio and Vidal-Meliá 2002 p.28). This forecast is far higher than originally thought due to errors in projections about future obligations – originally it was believed that fiscal costs would eventually diminish under privatization (Ibid). Fiscal costs in Chile are elevated in part by the obligation to provide subsidies for workers failing to accumulate enough capital to earn a minimum pension.

So it's not that the Chilean system didn't reduce government spending -- in fact, we can see that government spending on Social Security has been falling decade by decade, representing an ever smaller percentage of an ever larger GDP. The fact that this improvement is not as good as originally forecasted is hardly a failure, and certainly not a failure to deliver on a "promise." Further, by saying that "government stepped back in to save" people from being "condemned...to dire poverty," he misrepresents that providing a minimum pension was all along an intentional feature of the system -- it's not that the system failed, and so the government had to "step back in." Government was "in" all along. Finally, nothing in Kay's paper explains why the government's obligation was triggered -- Krugman leaves us to assume that it's due to some systemic failure of privatization, but he really has no idea what's behind it.

Krugman goes on to suggest that the same thing is happening in Britain:

Its Pensions Commission warns that those who think Mrs. Thatcher's privatization solved the pension problem are living in a "fool's paradise."

This is an utter misrepresentation of what the Pension Commission said. In its 2004 report, the "fool's paradise" it is talking about is the 1990's investment environment for corporate defined benefit pension plans. They are not issuing any "warning" or other opinion about "Mrs. Thatcher's privatization." Krugman simply made that all up.

Tim Worstall has a lot to say on his blog about other Krugman statements about Britain's system.

Update... [12/18/2004] Bruce Bartlett adds:

You should have mentioned that the Fed paper says right on the cover page that it is not to be cited without permission. You should check with the author to see if Krugman asked for permission. I assume not.

Not just college texts. At a meeting of the nuns who chose elementary reading texts for the diocese schools in Chicago some decades ago, the head honcho nun praised a look-say basal reading series that nearly destroyed American literacy, and a voice from the back of the room quipped, "C'mon Sister, we know they buy you a new car every year!"

Or take Indiana, where I convinced a then-very-young aide to the governor named Dan Quayle to give the new Open Court (phonics) reading program a special test (in some of the worst schools in Indianapolis) after the OC sales manager told me the state bidding process was rigged. OC offered to train the schools' teachers and provide all the textbook materials; if the test scores at the end of the first year were good, Dan said he would go to bat for us with the state textbook Commission. The results were spectacular, the "broken window schools" outperforming even many of the better city schools in first grade reading.

Dan did a great job monitoring the test, and securing the agreement of a majority of the Commission members. "It's a done deal," he in effect told me prior to the formal vote; a closed-door meeting was held; OC was not selected as one of the five publishers whose elementary reading products could be paid for by state funds; afterwards those who had promised Dan a vote for OC all said to him the same thing: "You did not tell me that if I voted for that OC my [brother, sister, aunt, etc.] would lose his state job!" It turned out one of the textbook salesmen (for a very prominent publisher) was also the head of patronage for the Republican Party in Indiana. When the Democrats were in, the same situation obtained.

That is how textbooks are often sold -- rarely on the merits -- at the elementary and secondary school level, in "adoption" states. It's one of the most disgusting scandals in America, and no one in the mainstream media will touch it -- despite my efforts and those of others over the last thirty years to steer education writers and investigative reporters into this maw --apparently because most MSM companies also have textbook subsidiaries or affiliates.

Back in the fifties, in Mississippi, when schools were "separate but [allegedly] equal," the publisher mentioned above "influenced" itself into a statewide adoption of their look-say (also known as "sight reading," or "word recognition/word memorization" pedagogy) texts, but for the white schools only. The black schools got the hand-me-down traditional Lippincott (I think it was) phonics-based texts. And so for a several years black reading scores in Mississippi were higher than white scores. Did the white schools change back? Of course not -- the administrators were all "influenced."

This has been repeated thousands of times since the 1950s, when textbook business started to became cartelized (now shrunk to about five large companies, most parts of even larger education/entertainment conglomerates). The cartel even conspires to prevent competition by lobbying through state laws which say, roughly, no state money can be spent on a textbook series with a copyright older than "X" years. In other words, a tried-and-true textbook series which really teaches kids how to read -- like that of the small firm Open Court, which consequently was forced to sell its superb program to McGraw Hill -- has to be scrapped or completely revised every "X" years, at the cost of $20+ million, an amount only the giants can afford. (No time and space to veer off into the role the teacher-training university professors and the teachers unions play in all this!)

California went from near first in the nation in reading scores (literacy) all the way to second worst, next to last-place. Mississippi -- because of its disastrous, corrupt single-publisher adoption law in effect since the sixties (until the nineties). Several school generations of look-say-taught, barely-literate, largely innumerate kids explain a lot about the politics of that state today!

Since national and state governments are the customers for textbooks, Wheeler's Law needs to be applied to this problem. "Wheeler's Law," invented years ago by Tim Wheeler who wrote the very entertaining brief paragraphs in the front section of National Review for about twenty-five years, before the humorless new regime of kids there sadly dispensed with his talent, says: "The way to get rid of corruption in high places is to get rid of the high places."

This is an economical way to restate the principle of subsidiarity, first mentioned in the papal encyclical De Rerum Novarum about a hundred years ago, and now eloquently championed in the academic journals by Georgetown government Professor George Carey, and of course by libertarians and small government conservatives everywhere.

In other words, return all education taxing and spending and decision-making to local communities (scrap President Bush's ill-advised "Leave No Child Behind" boondoggle as well as Jimmy Carter's creation, the Department of Education). Remove the national and state governments from the process virtually entirely. They can (1) inspect schools for health safety and so on; (2) in the traditional state interest of equality and an educated citizenry, it can give every child a voucher; and (3) also oversee a statewide testing program. If a school wishes to provide a crackpot curriculum, let the market -- children and parents with vouchers to spend -- and the test scores (reading, math, American history, science) decide the school's fate, not a government bureaucrat with an ideology of any kind, left or right, sane or crazy.

Meantime, the textbook publishers will find it simply uneconomical to, ahem, "unduly influence" tens of thousands of small school districts (as opposed to fifty states' textbook bureaucrats), and the market will see the pedagogies that do not work driven from the schools -- by decisions made by results-oriented, local parents and teachers -- and the rebirth of nearly universal literacy and numeracy will return to this country.

There is nothing wrong with the kids in this country or our gene pool (less divorce and illegitimacy would certainly improve the kids' psychological health, of course). At the early grade levels they are among the best in the world, when tested. After eight years of elementary school, they have fallen to near the bottom. Why ? America's textbook publishers are one reason.

To be sure, many Democrats will reflexively charge that price indexing will "cut" benefits for seniors. However, President Bush has explicitly pledged to protect benefits for both today’s retirees and near-retirees. Secondly, only in Washington would slowing the rate of increase in overall benefits from eighteen-fold to eight-fold be considered a "cut." Finally, the politics of Social Security have dramatically changed: Today’s young workers would gladly give up all of their future Social Security benefits for the chance to invest part of their payroll taxes in an account that they would own and control.

...it's a solvent system until 2052, and with very minor variations can be good for another century, as Paul Krugman, Professor of Economics at Princeton, pointed out recently, writing in the New York Times.

My contention: Social Security privatization is not just unlikely to succeed, for various reasons that are subject to discussion. It is mathematically certain to fail. Discussion is pointless.

Why would Sullivan think Kinsley is asking for discussion by bloggers or anyone else when he starts by saying "discussion is pointless" and positions his own view as "mathematically certain"?

Also, note Kinsley's use of the word "privatization" -- as though the proposal on the table were to eradicate any role for government in Social Security, and turn the whole thing over to Halliburton. The issue here is personalization -- individually owned and controlled personal investment accounts within the context of a government-mandated and government-operated program. Well, let's just write that off as the way liberals talk, and proceed anyway.

The usual case against privatization is that (1) millions of inexperienced investors may end up worse off, and (2) stocks don't necessarily do better than bonds over the long-run, as proponents assume. But privatization won't work for a better reason: it can't possibly work, even in theory. The logic is not very complicated.

Sigh. When people say things like "The logic is not very complicated," they are saying "If you disagree with me, you are stupid." I guess when one is the editorial page editor of the Los Angeles Times, one feels he can speak so arrogantly. But let's set that aside and move on.

1. To "work," privatization must generate more money for retirees than current arrangements. This bonus is supposed to be extra money in retirees' pockets and/or it is supposed to make up for a reduction in promised benefits, thus helping to close the looming revenue gap.

2. Where does this bonus come from? There are only two possibilities: from greater economic growth, or from other people.

I'll grant these two premises.

3. Greater economic growth requires either more capital to invest, or smarter investment of the same amount of capital. Privatization will not lead to either of these.

I'll grant the premise in the first sentence, but not the conclusion in the second. I'll argue that personal accounts will start with smarter investment of the same amount of capital, and lead almost immediately to a larger economy in which there is more capital to invest.

a) If nothing else in the federal budget changes, every dollar deflected from the federal treasury into private social security accounts must be replaced by a dollar that the government raises in private markets. So the total pool of capital available for private investment remains the same.

This would be true on day one, when personal accounts are first established. But this would not be true over time. First, we cannot assume that "nothing else in the federal budget changes." Currently Social Security tax revenues in surplus above disbursements are accumulated in a so-called "trust fund" which, in turn, invests the money in Treasury debt -- whereupon the government spends it. It is not at all clear that "nothing else in the federal budget changes" if this source for funding government spending were to be reduced. Kent Smetters of Wharton and NBER has offered credible empirical evidence (Smetters, 2003) that, in fact, levels of  federal spending are closely correlated with cumulative Social Security surpluses (indeed, Smetters shows that the pattern has been for spending to exceed the surpluses). This suggests that a dollar diverted into private accounts would, over time, be less than fully offset by a dollar in federal borrowing.

Second, for reasons that I will argue later, personal accounts will lead to faster economic growth and an increase in the pool of capital.

b) The only change in decision-making about capital investment is that the decisions about some fraction of the capital stock will be made by people with little or no financial experience. Maybe this will not be the disaster that some critics predict. But there is no reason to think that it will actually increase the overall return on capital.

Setting aside how elitist this is, it's also just flat-out wrong. Personal accounts not only change who makes investment decisions -- they also expand the scope of the decisions that are possible to make, irrespective of who makes them. Right now the decision is to invest capital saved against future Social Security benefit payments entirely in Treasury securities. Personal accounts would free some of that capital to be invested in other ways. Yes, some of it -- perhaps a large fraction of it -- would be invested in Treasury securities, just as it is now. But surely some of it -- also perhaps a large fraction -- would be invested in equities -- securities with higher expected returns and higher expected risks. So there is every reason to think that personal accounts would, in fact, "increase the overall return on capital."

En passant, it should be noted that the "financial expertise" required of personal account holders is actually fairly minimal. I have no doubt that the Bush administration's eventual proposal for personal accounts will restrict them to investing in a small selection of professionally managed, highly diversified and low-cost index funds (the well established Thrift Savings Plan for federal employees works this way -- very successfully -- and will be the template). Pretty much all the personal account holder has to do is make a high-level decision between stocks and bonds. We cannot be sure that personal account holders will make the same decisions that professional pension fund managers do, to invest heavily in equities. But considering that the Social Security trust fund currently doesn't invest in equities at all -- thus going counter to the best practices of virtually all pension professionals -- even terribly mismanaged personal accounts would move the overall system toward a more fruitful allocation of assets, provided they made any move at all in the direction of greater allocation to equities.

4. If the economy doesn't produce more than it otherwise would, the Social Security privatization bonus must come from other investors, in the form of a lower return.

When trillions of dollars invested to fund future retirement benefits are allocated more sensibly through personal accounts -- compared to their current misallocation entirely to Treasury debt and none to equities -- then the economy will produce more than it otherwise would. To believe otherwise is to believe that it doesn't matter how capital is invested as between riskless government securities and risky equity securities. Since I fundamentally dispute Kinsley's "if," there's almost no point in discussing his "then" -- but let's follow his reasoning anyway, and see where it leads. 

a) This is in fact the implicit assumption behind the notion of putting Social Security money into stocks, instead of government bonds, because stocks have a better long-term return. The bonus will come from those saps who sell the stocks and buy the bonds.

No, it's not "in  fact" or in any other way "the implicit assumption" -- it's Kinsley's straw-man assumption. The actual assumption in the minds of thoughtful advocates of personal accounts is that, when trillions of misallocated dollars become freed from legislatively imposed misallocation, the capital markets become more efficient and the entire economy becomes more productive, faster growing, and larger as a result. There is no need, therefore, to make zero-sum game arguments that any gains for personal accounts must be offset by opportunity costs suffered by those who sold their equities to personal account holders.

b) In other words, privatization means betting the nation's most important social program on a theory that cannot be true unless many people are convinced that it's false.

Shades of Al Gore and his characterization of personal accounts as a "risky scheme." Fortunately, though, no one is betting on this "theory" except Kinsley -- it's his straw-man.

c) Even if the theory is true, initially, privatization will make it false. The money newly available for private investment will bid up the price of (and thus lower the return on) stocks, while the government will need to raise the interest on bonds in order to attract replacement money.

We all take the Efficient Market Hypothesis seriously, but this is the Nihilistic Market Hypothesis. According to this logic, any time any investor makes a trade -- ever -- prices adjust to un-do any advantage for having made the trade. So if you hold cash, there is never any reason for investing it in stocks, because your buy order will move stock prices higher by an amount sufficient to make it not worth it to you. And, obversely, I suppose, if you want to sell stocks to raise cash, you will lower the stock price to a point where selling isn't worth it, either. In other words -- no investor should ever do anything, ever. The status quo is perfect -- or at least it's the best you can do -- by definition.

In Kinsley's zero-sum world of investment nihilism, anytime one investor is wise or lucky enough to earn superior returns, somewhere there is another "sap" who earned lower returns. Thus, from an economy wide or "social" point of view, making investment decisions is pointless at best, and (here's the subtext) anti-egalitarian. But Kinsley completely ignores the fact that dynamic markets, with their constantly changing prices and their constantly changing cast of characters -- winners and losers -- is what points capital toward its most productive uses. This process is of superb "social" value, and in an important sense makes everyone a winner -- even those who don't participate directly in equity markets

Sure, increased demand for equities will raise equity prices. Indeed, the long-term legislated misallocation of capital controlled by the Social Security system may have kept equity prices artificially low for many years. Higher stock prices arising from more efficient allocation would be a windfall for all existing holders of equities, representing an important increase in the value of the capital stock (and at the same time, encouraging innovation and growth by lowering the cost of capital). By the way, Kinsley's concern about rising prices flatly contradicts his earlier claim that "the total pool of capital available for private investment remains the same." His own assertion that equity prices will rise proves that capital will increase.

Yes, all else equal, higher equity prices mean that one shouldn't expect the same returns from equities as one would have if prices had not risen. But this does not prove -- and Kinsley says nothing else to prove it -- that this reduced return is not still well above the return one could expect from Treasury bonds, or that one still wouldn't be better off making the switch to equities. At the same time, others with different attitudes about risk and return might be better off making the shift in the other direction in light of the higher prices -- that doesn't make them "saps." And remember, all else is most assuredly not equal -- higher equity prices would be the result not of just sheer auction demand, but rather an equilibration at a higher level representing the new expected returns in a more rapidly growing economy now freed from legislated misallocation of capital.

d) In short, there is no way other investors can be tricked or induced into financing a higher return on Social Security.

There's no trickery involved. The core idea here is that the advent of personal accounts would end decades of legislated misallocation of capital, which would have a salutary effect on economic growth.

5. If the privatization bonus cannot come from the existing economy, and cannot come from growth, it cannot exist. And therefore, privatization cannot work.

Q.E.D.

The "bonus" will come from growth. But there's that other matter I mentioned earlier, too, which Kinsley entirely ignores (and which I have no doubt he won't like). Personal accounts will deny politicians a captive buyer of federal government debt. When that captive buyer is freed, government spending will have to be reduced.

Oh, and there's another little matter that Kinsley ignores. It's a liberal blind-spot, I guess. Personal accounts are a good idea because we are a free people who ought to have a say over how our money is invested. And after all, it is our money. Isn't it?

Posted by Donald L. Luskin at 1:05 PM | link  

Wednesday, December 15, 2004

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