The Next Big Thing
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Wednesday August 1
SmartMoney.com - Ahead of the Curve
By Donald Luskin
WE MAY BE on the brink of a once-in-a-decade investment opportunity, a rare chance to catch a huge change in the economy and the markets. And it's still early on this one — you can grab this one before it becomes part of the conventional wisdom, while the profit opportunities are at their greatest. That's why it's the subject of this, my first weekly ``Ahead of the Curve'' column for SmartMoney.com.
The opportunity is the possibility — and I admit that at this point it's still only a possibility — that President George W. Bush will succeed in his stated intention to restructure the Social Security system to include individually managed accounts that could be invested in the stock market.
Now, most people think Bush's initiative is just a false alarm, like former President Bill Clinton's failed attempt to nationalize the health-care industry at the same early point in his presidency. But if it does happen, it will be one of those exogenous shocks that sets off an investment megawave, for good or for ill — like the oil crisis in the 1970s and the resulting hyperinflation; like the tax cuts and deregulation initiatives in the 1980s, and the resulting restructuring of Rustbelt America; and like the end of the Cold War in the 1990s, and the resulting boom in civilian technology.
It's hard to think about these investment megawaves before they happen because the politics behind them can be very distracting. So try to forget about how you may feel about the politics of Social Security. Just think like an investor: Ask yourself what would happen to the economy and the markets if people could invest their Social Security contributions themselves, in individually managed accounts.
The impact would be enormous, because the number of people involved and the number of dollars involved is enormous. Social Security covers 142 million American workers — that's almost four times the number covered by 401(k) retirement plans. Consider what might happen when those 142 million workers are suddenly given individual accounts they can invest in the stock market. Of course, not all of them will choose to do so. But many will, and we may see a repeat — in an even more extreme form — of the extraordinary market volatility we saw in the late 1990s, when the online-investing revolution drew millions of individuals into stock investing for the first time.
For 2000, the Social Security system collected $490 billion from payroll taxes and interest on its bond portfolio — that's about 4.5% of America's gross domestic product, and more than the market cap of General Electric (NYSE:GE - news), the world's most valuable corporation. Right now, $358 billion of that is being paid out in benefits, and the remaining $132 billion is invested in Treasury bonds. As soon as any of that $132 billion a year gets redirected to the stock market, the balance of supply and demand between equities and fixed income could shift dramatically — in favor of equities.
Not only would the introduction of individually managed Social Security accounts bring new investors into the equity markets, but it would also create incentives for investors already in equities to invest even more. It's all a matter of taxes. Presumably, contributions to an individual Social Security account would be tax exempt, and investment profits in the account would not be taxed until balances are withdrawn when the investor retires — just the way a 401(k) plan works today. That tax treatment raises the after-tax return on risk-bearing, and makes riskier assets more attractive. That not only causes investors to move from bonds to stocks, but it also causes them to move assets already invested in equities from conservative stocks to aggressive stocks.
These would be the first-order results of creating and funding millions of new stock-market investment accounts for millions of new investors, and offering them powerful tax incentives. But the second-order results may turn out to be even more important. Over time, it will almost surely be the case that the investment results in these new accounts will be superior to the returns promised by the existing Social Security system — and if that's true, the trillions of dollars in new wealth that is created would vastly expand the size and scope of the consumer economy, setting in motion a virtuous circle that would enhance the value of the very equities that were rendered more attractive thanks to the first-order effects.
Why am I confident that the investment results would be better? After all, millions of the new individually managed accounts will be in the hands of people who don't know a stock from a hole in the ground. And even savvy investors have been battered by the market over the last 16 months, which has taken some momentum away from the push for private accounts. But I think that's shortsighted, because the returns from the existing system, when measured as you would measure any other kind of investment, are so blindingly bad that just about anything else would have to be better.
What are those returns? Well, that depends on who you are — whether you are male or female, single or married, one-earner or two-earner (all of which raises some very real fairness issues, but let's leave that aside for the time being). According to the Office of the Actuary of the Social Security Administration, for Americans born in 2000, the rate of return on a working lifetime of paying Social Security taxes, and then collecting the promised benefits during retirement, is only 0.86% per year for a single male, only 1.25% for a single female and 1.88% for a two-earner couple. The single-earner couple makes out the best, with 3.02% — but even that's nothing to write home about. You'd have to mess up pretty badly in your individual account to get returns that bad over the long term.
So far, all my arguments are for the bullish impacts on the economy and the markets if Bush's initiative succeeds. Now let's look at the other side of the coin — the bearish impacts if it fails.
Even the staunchest supporters of the existing Social Security system admit that it will face severe economic challenges at some point in the future, as the number of young workers paying into the system declines in relation to the swelling number of retired workers drawing benefits from it. Under the existing paradigm, there's simply no way to fix that problem without either raising the taxes that young workers pay, or reducing the benefits that the retired workers get. And either way it works out the same: The already horrible rate of return in the system simply gets worse. At some point, it even goes negative. But long before that, the combination of increasingly intolerable burdens on young people and broken promises to old people will induce economic dislocations that will make a fiasco like the savings-and-loan crisis look like a hayride.
And don't draw too much comfort from that almost $1 trillion sitting in the Social Security Trust Fund. It's all invested in Treasury bonds — which makes about as much sense as having the General Motors (NYSE:GM - news) pension plan invest in bonds issued by General Motors. You can't collateralize someone's promise to pay by having him invest in his own bonds — after all, bonds themselves are nothing more than promises to pay.
So in 20 or so years when the Treasury bonds in the Trust Fund have to start being sold to pay benefits, we're going to see an awful lot of supply hitting the fixed income markets. Then we'll find out what those promises are really worth. And remember, in the end there are only three ways for the government to redeem those bonds — by raising taxes, running the printing press or slashing spending.
It should be obvious that raising taxes and inflating the currency would be bad for the economy and the markets — but would it be such a bad thing to slash spending? Ordinarily, probably not, because ordinarily spending cuts would be made to facilitate tax cuts. But a spending cut without a tax cut is just a tax increase by another name — instead of taking citizens' money in the form of higher taxes, citizens are given fewer government services. So you can run, but you can't hide. When those Treasury bills come due, it's going to hurt.
Bush's efforts to restructure Social Security are going to get covered in the press as grand political melodrama. The financial news will all be about Alan Greenspan's speeches and guessing whether Cisco Systems (NASDAQ:CSCO - news) is going to make its quarter. But don't be fooled by the conventional wisdom — there's nothing else on the horizon that will have remotely as much impact on the markets over the next decade as what happens with Social Security.
Donald Luskin is an investment manager and CEO of MetaMarkets.com. You may contact him at don@metamarkets.com. At the time of writing, funds he manages had positions in General Electric and Cisco. |
