Many, many posts ago I promised to unveil my plan for fixing Social Security. I have duly kept up with the continuing debate about Social Security “privatization,” which is hardly what the President’s plan envisions. (There’s a selected bibliography at the bottom of this post.) Having weighed it all, I am reinforced in my belief that the only way out of the Social Security “mess” is to phase out Social Security.

Why? As a bleeding-heart libertarian who wants the best for others as well as for himself, and who understands that economics is a positive-sum game, I say this: The best way to incentivize people to work hard, to acquire new and higher-paying skills, and to stay sober is to allow them take responsibility for their old age. Put them on notice (reasonable notice, of course) that they are responsible for themselves; unless they can count on family, friends, or private charity to see themselves through old age, they should consume less, save more, and invest wisely.

What’s the worst that can happen? Some form of public assistance would be demanded for the truly needy (and for their fellow travelers, the lazy and the imprudent), and by those who simply bleed envy or pity at the thought of “excessive” income inequality. But the accompanying tax burden would be much smaller than the burden that now hangs over future taxpayers if we try to redeem anything resembling the “promises” implicit in the present Social Security scheme. Moreover, the demise of Social Security would give added impetus to the coming economic boom (see here and here), as the higher rate of personal saving necessitated by the phase-out of Social Security would finance additional investments in productivity-enhancing growth. Lower taxes and a more robust economy would also foster a resurgence of private charity, in aid of the truly needy (if not the lazy and imprudent).

Here’s my plan:

1. Abolish Social Security payroll taxes as of a date certain (Abolition Day).

2. Pay normal benefits (those implicitly promised under the present system) to persons who are then collecting Social Security and to all other qualifying persons who have then reached the age of 62.

3. Persons who are 55 to 61 years old would receive normal benefits, pro-rated according to their contributions as of Abolition Day.

4. The retirement age for full benefits would be raised for all persons who are younger than 55 as of Abolition Day. The full retirement age is now scheduled to rise to 67 in 2027; it should rise to 73 by, say, 2020. Moreover, partial benefits would no longer be available to persons between the age of 62 and full-retirement age.

4. Persons who are 45 to 54 years old also would receive pro-rata benefits based on their contributions as of Abolition Day. But their initial benefits would be reduced on a sliding scale, so that the benefits of those persons who are 45 as of Abolition Day would be linked entirely to the CPI rather than the wage index.

5. Persons who are younger than 45 would receive a lump-sum repayment of their contributions (plus accrued interest) at full retirement age, in lieu of future benefits. That payment would automatically go to a surviving spouse or next-of-kin if the recipient dies intestate. Otherwise, the recipient could bequeath, transfer, or sell his interest in the payment at any time before it comes due.

6. The residual obligations outlined in points 2-5 would be funded by a payroll tax, which would diminish as those obligations are paid off.

Repeat, with appropriate variations, for Medicare and Medicaid.

SELECTED BIBLIOGRAPHY

The Official State of Social Security
2004 OASDI Trustees Report: Contents
2004 OASDI Trustees Report: Conclusion
The looming deficit problem: Table VI.F8.–Operations of the Combined OASI and DI Trust Funds, in Constant 2004 Dollars, Calendar Years 2004-80
The underlying causes: Shrinking worker-retiree ratio, increasing longevity, and wage indexing

Some Alternative Solutions to the Problem
General Accounting Office
Brookings Institution
Cato Institute
Laurence J. Kotlikoff

Analytical Perspectives of Other Bloggers
Arnold Kling: Fighting Murphy (also known as “A Social Security Policy Primer”)
Alex Tabarrok: The Microeconomics of Social Security Privatization
Tyler Cowen: Should We Privatize Social Security?
Arnold Kling: The Cost of Privatization
Will Wilkinson: How Much Does SS Screw You?
Alex Tabarrok: Prescott on Social Security Reform
Tyler Cowen: Social Security and Our Future
Tyler Cowen: Freezing Social Security Benefits
For much more, browse this list of articles by Arnold Kling, many of which are about Social Security.

My Posts on Social Security and Related Issues
Social Security Is Unconstitutional
Why It Makes Sense to Privatize Social Security
P.S. on Privatizing Social Security
Fear of the Free Market — Part III
Social Injustice
Let’s Just Say He’s a Bit Evasive
A Good Reason to Favor the “Ownership Society”
That Mythical, Magical Social Security Trust Fund
The Real Social Security Issue
Social Security — Myth and Reality
Nonsense and Sense about Social Security
More about Social Security
Social Security Privatization and the Stock Market
Oh, That Mythical Trust Fund!
Understanding Economic Growth
The Problem with Voluntary Personal Accounts

UPDATED 02/12/05 (new text in bold)

The so-called national debt is really the debt of the government of the United States of America. I have written before about the debt and why it isn’t all that important, in spite of the hysterics it invokes. Some writers (The Skeptical Optimist via EconoPundit, for instance) try to diminish the importance of put the debt in perspective by comparing its size with GDP, which they take as an indication of “our” is analogous to a standard measure of a private debtor’s ability to service the debt.

I have two problems with that depiction of the debt. First, that depiction assumes it might be taken by as a suggestion that it’s necessary to pay off the debt* — as if it were a home mortgage — which is a notion that I have previously debunked. (Steve Conover, The Skeptical Optimist, doesn’t mean to suggest that the debt must be paid off. In fact, he has written several excellent pieces about the debt and why it needn’t be repaid.**) My second objection arises from the first, and is more fundamental. The debt really is a measure of the extent to which spending by the U.S. government has exceeded taxes collected by the U.S. government since 1789. In other words, the damage has already been done: first, by government spending, which on balance diverts resources from productive uses; second, by the inflationary effects of government spending, which deficits merely aggravate. (For more on those two points, see the preceding post — especially the final four paragraphs.)

The notion of paying off the debt — or measuring “our” ability to pay it off — is an unfortunate and inappropriate carryover from personal and corporate finance. (The notion persists in spite of the writings of sensible thinkers like Steve Conover.) We, the citizens of the United States, already have paid off the debt of the United States government by allowing that government to commandeer resources from the private sector — a self-inflicted sacrifice that can be measured in the trillions of dollars, and which encompasses not only the debt but most of what government has spent on activities other than defense and justice. Why should we now worry about paying off the shadowy residue of the debt, which is nothing more than an approximate measure of the wasteful ways of the U.S. government? Who’s going to make us fork over, the shade of John Gotti?

P.S. A reader says:

You leave out one small detail from your post – interest on the debt. That is not an accounting entry and is most definitely not “in the past.” It’s the present and the future and it’s very real. $135.46 billion in FY2005.

And of course, fluctuating interest rates notwithstanding, the debt is very good proxy of the national interest burden, which must be paid in cash today by taxpayers today.

My reply:

Interest on the debt is real — but it’s essentially a transfer payment from one set of persons (taxpayers) to another set of persons (those who hold the debt). Because the two groups overlap, it’s sort of like robbing Peter to pay Peter and Paul. (Where’s Mary when you need her?)

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* The usual meaning of “debt service,” in my experience, is “interest payment plus repayments of principal to creditors, that is, retirement of debt,” which is the definition given in The New York Times Financial Glossary.

** Recommended articles and posts by Steve Conover:

Deficits, the National Debt, and Economic Growth: Summary

Deficits, the National Debt, and Economic Growth: Who Owes Whom? Think.

How to Neutralize the National Debt’s Interest Burden

Deficits, the National Debt, and Economic Growth: We’ll Never Have to Pay It Back

Many of those who wish to preserve Social Security as we know and love it will insist that the Social Security trust fund is real. The usual argument goes like this: Yes, the trust fund holds government bonds. But if government bonds are a real asset to private investors, they must be a real asset to the trust fund. Wrong.

If the Social Security Administration (SSA) had invested net Social Security receipts in stocks, corporate bonds, and private mortgages — or had stashed the receipts in many, many passbook savings accounts, à la W.C. Fields — the trust fund could be a real asset. Why? Because SSA would have simply done for individuals what they could have done for themselves, namely, held their savings in the form of claims on real assets (business equipment, homes, and automobiles, for instance) and/or the future income produced by those assets.

But the problem is bigger than SSA’s failure to invest forced savings in claims on real assets. SSA is just a branch of the U.S. government. Even if SSA had wanted to take its net receipts to the bank, it couldn’t have. A robber would have intercepted SSA on the way to the bank, taken the money, and blown it on booze. Actually, what happened was that the rest of the U.S. government grabbed SSA’s net receipts and blew them on this welfare program, that regulatory effort, and other “public services.” Unlike the typical thief, the U.S. government then handed SSA a bunch of IOUs.

Now, tell me where the real asset is. It’s not to be found in the creation of government programs or even in the physical assets employed by government in those programs. For, the economic benefits that sometimes flow from government activities are far more than offset by the economic disbenefits of government activities (a). A real asset must — on balance — add to wealth or income, not subtract from it.

But what about all those private investors who hold government bonds? Aren’t they holding real assets? Well, they’re holding financial assets, which give them a claim on real assets. Let’s take Citizen Kane as an example. Suppose he has scrimped and saved $1 million. He could place that amount in some combination of stocks, corporate bonds, mortgages, and savings accounts, but he chooses to buy government bonds, instead. Now, Citizen Kane has already done his bit for the creation of real assets merely by saving $1 million in the first place. That is, through the magic of macroeconomics, the $1 million that he forbore to spend on this bauble, that bangle, and another bead enabled the creation of $1 million in real capital (plant, equipment, business software, etc.), which fosters economic growth.

Thus, in the first approximation, where Citizen Kane actually puts his $1 million is less important than the fact the he has saved (not consumed) $1 million, so that others (businesses, to be precise) can direct $1 million worth of resources into the creation of capital. If he chooses to put the $1 million in government bonds, that’s his lookout. Those bonds have a market value, which will fluctuate just like the market value of all financial assets. But the marketability of the bonds simply means that he can claim his share of the wealth that was created when he saved $1 million in the first place.

Government bonds held by government entities, on the other hand, don’t even pretend to be claims on real assets. They’re nothing but pieces of paper whose value can be realized only through taxation. Well, government can tax us without going through the charade of creating government bonds. Thus the bonds held by the SSA amount to nothing more than a superfluous excuse to raise our taxes. The power to tax is a real asset only to those who are net recipients of the taxes that are collected. By the same token, the power to tax is a real liability to those who are net payers of the taxes that are collected. Asset = liability = zero.

So much for those “real assets” in the Social Security trust fund.

But I’m not through discussing the shell game that goes by the exalted name of “public finance.” There’s a lot more to it than the mythical Social Security trust fund.

Government spending, however it is financed, is a way of commandeering resources that otherwise would flow to private consumption and investment (i.e., capital formation). To the extent that government activities fail to pay their own way by yielding goods and services of equivalent value — and they don’t (a) — the resources used by government are simply wasted — thrown down a rat hole (b).

Government nevertheless goes through the charade of taxing and borrowing to finance its activities, instead of simply sending goon squads to impress those resources into government service. Thus the total amount of money in circulation remains more or less unaffected by government spending, while the total output of real goods and services (including capital assets) is reduced as government commandeers resources. The result, of course, is inflationary (c).

In particular, the injection of government bonds into financial markets, with the help of the Federal Reserve’s authority to create money, means that the total nominal value of financial assets is at least the same as it would have been in the absence of government borrowing, and probably higher (d). At the same time, government spending reduces the output of real assets, thus diluting the value of financial assets. Financial assets are fungible, so the holder of a government bond has the same claim on real assets as the holder of, say, a share of Berkshire Hathaway stock.

Think of it this way: Every time the government issues a new bond because it’s spending more money, your real share of stock in America’s economy becomes worth less, even if the nominal price of the stock rises. Depressing, isn’t it?
__________
a. An official estimate of the annual benefits flowing from federal regulations places the value of those benefits at less than $200 billion. But the annual cost of those regulations — including the hidden costs not included in the government estimate — is approaching or has exceeded $1 trillion, as discussed here, here, here, and here. But that’s just the tip of the iceberg that rammed into the American economy about 100 years ago, as I will show in Part V of “Practical Libertarianism for Americans.”

b. I exclude most expenditures on defense and justice from that indictment.

c. That is, government spending causes prices to be higher than they otherwise would be because total spending remains about the same as it would have been, whereas real output is reduced. Whether or not those nominal prices rise (the usual meaning of inflation) depends on the rate at which government spending grows relative to the growth of output of real consumer goods, services, and assets.

d. The total nominal value of financial assets is approximately unaffected by government borrowing, if you accept the crowding-out theory. The total nominal value of financial assets rises with government borrowing if you don’t, if you don’t accept the crowding-out theory. I don’t.

A “senior administration official,” speaking on background before President Bush’s State of the Union speech on February 2, said this:

For individuals who were born in 1950 or later, they would have the opportunity — the voluntary opportunity — to participate in personal accounts. If they wished, they could not choose a personal account and they could stay entirely within the current system. The President has said we want to make sure that system is reformed to be fiscally sustainable. Certainly, though, individuals have the option of not taking a personal account and [receiving] the benefits that the traditional system would be able to pay.

What will happen, of course, is that those who choose to participate in personal accounts will draw larger benefits than those who choose to rely on solely on the traditional system. Why? The “return” on “contributions” to the traditional system will continue to shrink as the worker:retiree ratio shrinks. That “return” will be far less than the return earned on personal accounts, even those personal accounts that are invested solely in government bonds.

I predict that those who are foolish enough to remain in the traditional system will complain about the “unfairness” of it all when they reach retirement age and realize that they made a mistake. Congress, bowing inevitably to pressure from the powerful and ever-growing ranks of the elderly, will raise benefits payable on traditional accounts to a level consistent with the benefits payable on personal accounts invested in government bonds. That will necessitate higher payroll taxes, thus negating two important objectives of privatization: (1) to diminish, if not eliminate, the growing burden on workers, and (2) to stimulate economic growth by injecting more money into capital markets.

Privatization will fail to meet its objectives unless everyone who is eligible to open a personal account is required to do so, even if the account is invested only in government bonds.

I’d rather see Social Security abolished, of course, after paying off those who are collecting benefits or have “contributed” to the system. But abolition seems to be out of the question, so the next best thing is to convert Social Security from a transfer-payment Ponzi scheme to something resembling a real retirement plan.

In “More about Social Security,” I wrote:

As we know well from long experience, the course of the economy isn’t expressed by a smooth, upward rising curve of progress. Aggregate economic output can be thought of as a quantum phenomenon, in that it has many potential values at each point in time. Shocks and stimuli determine which of those potential values becomes reality. Shocks (e.g., the collapse of the American stock market in 1929) can lead to sharp and prolonged downturns that can be reversed only by strong stimuli (e.g., the mobilization for World War II). Despair feeds on itself, as does hope. And hope fuels the kind of creativity that we saw, for example, in the aftermath of the Civil War, when the rapid invention and adoption of new technologies and production processes took us to new heights of prosperity in the 1920s.

The same kind of creativity resurfaced in the late 1900s — spurred by the stimulus of an inflation-busting recession and significant cuts in marginal tax rates. Will it last? Will it take us to ever-higher levels of economic output? It might, but not as a matter of historical inevitability, as some suggest. Historical inevitability is what we see in the rear-view mirror of experience. Something must happen to spur the creation and adoption of new technologies that will take us to new economic heights.

Arnold Kling points to and quotes from a relevant article by Meir Kohn:

Growth does not mean movement along an equilibrium path but rather the unfolding of a complex process. At any moment the potential of the economy is not completely realized: unexploited opportunities for mutually advantageous exchange abound. Indeed the “potential” of the economy is not defined; it depends on the initiative and ingenuity of individuals. Individuals engaging in trading, innovation, and institutional change generate the process of growth, not only discovering potential but also creating it.

The secret ingredient, of course, is purposeful human behavior. As I have shown shown elsewhere, deterministic models of aggregate behavior are woefully inadequate to the understanding of economic and social phenomena.

Paul Krugman’s latest wrong-headed argument against the privatization of Social Security appears in today’s New York Times. Krugman says:

Schemes for Social Security privatization, like the one described in the 2004 Economic Report of the President, invariably assume that investing in stocks will yield a high annual rate of return, 6.5 or 7 percent after inflation, for at least the next 75 years. Without that assumption, these schemes can’t deliver on their promises. Yet a rate of return that high is mathematically impossible unless the economy grows much faster than anyone is now expecting.

Krugman can make all the economic assumptions he wants. And you know that he’ll make assumptions which “prove” his case. But he can’t argue with history.

The S&P 500 — reconstructed back to 1870, with dividends reinvested — grew at an annualized rate of 6.8 percent, after inflation. To repeat, that’s a real rate of return of almost 7 percent. What about all those ups and downs between 1870 and 2004? Well, an exponential fit of the growth curve for 1870-2004 gives an annualized return of precisely 6.5 percent — just what the professor ordered. If 135 years is a too-long run, how about the 59 years since the end of World War II? The rate of return for 1946 through 2004 was 7.4 percent. An exponential fit of the growth curve for 1946-2004 gives an annualized return of 7.1 percent. *

Krugman wants so badly to denigrate the benefits of privatizing Social Security that he’ll stoop to any sort of slippery argument. In this case, he makes the following key assertions (my comments are bracketed in boldface):

In the long run, profits grow at the same rate as the economy. So to get that 6.5 percent rate of return, stock prices would have to keep rising faster than profits, decade after decade. [In fact, the total return on stocks — including reinvested dividends — has been rising faster than the economy for at least 13 decades. And it has been rising at an annualized rate of 6.5 percent.]

The price-earnings ratio – the value of a company’s stock, divided by its profits – is widely used to assess whether a stock is overvalued or undervalued. Historically, that ratio averaged about 14. Today it’s about 20. Where would it have to go to yield a 6.5 percent rate of return? I asked Dean Baker, of the Center for Economic and Policy Research, to help me out with that calculation (there are some technical details I won’t get into). Here’s what we found: by 2050, the price-earnings ratio would have to rise to about 70. By 2060, it would have to be more than 100. [The PE ratio on the S&P 500 (as reconstructed back to 1871) has been drifting generally upward. There have been sharp rises and dips in the PE ratio, because of market bubbles and crashes, but it is clear that the perception of risk has diminished with time and that stocks can command higher PE ratios than they did in the past. A statistical analysis of the relationship between PE and total stock-market returns (including dividends), based on 103 30-year periods ending in 1901 through 2004, produces absolutely no relationship between PE and future returns. In fact, for the 134 years (1870-2004) in which the total real return on the S&P 500 averaged 6.5 percent a year, the year-end PE ratio on the S&P 500 ranged from 5 to 33 — nowhere near the PE ratio of 70 or 100 demanded by Krugman.]

Krugman is simply determined to preserve a wasteful, socialistic relic of the Great Depression. He gives away his game in the first sentence of his article: “The fight over Social Security is, above all, about what kind of society we want to have.” The rest is a rather clumsy attempt at economic sleight-of-hand. Well, as usual, Krugman has fumbled his trick.

__________

* I’ll have more to say about the significance of stock-market returns, and their relation to GDP, in Part V of “Practical Libertarianism for Americans.” For now, I’ll just tantalize you with some of the numbers that I’ll document and discuss in that future post.

Well, I’m 95-percent “Austrian” according to my score on a 10-question quiz at the website of the Ludwig von Mises Institute:

Your score is: 95 / 100.

Each question is followed by an Austrian School answer (10 points), a Chicago School answer (5 points), a Keynesian-Neoclassical School answer (2 points), and a Socialist answer (no points)–all broadly defined….

1. What is the correct economic status of private property?

A. Property is at the heart of most serious inequalities and oppressions in modern civilization. Only by regulation, transfer payments, redistribution of property, and common ownership can society arrive at fairness, justice, and human dignity for all. Socialist answer

B. Property is a naturally arising relationship between human beings and material things. Property and enforceable property rights make possible economic calculation, a wider and more productive division of labor, and therefore increasing levels of prosperity. Indeed, civilization itself is inconceivable in absence of private property. Any encroachment on property results in loss of freedom and prosperity. The Austrian answer. http://www.mises.org/libprop.asp

C. Property is central to prosperity and economic growth. Accordingly, it is of the utmost importance that the state, or more abstractly the law, maintain and modify the bundle of property rights in such a way as to allocate transactions costs in such a way as to promote maximum growth and economic efficiency. Property does not arise naturally, but is the end product of the legal system. Chicago answer

D. Property is an important component of our social system but its status as a “right” is contingent. It must be subject to regulation and modification for the general good. The state must intervene to prevent abuses of economic power, even at the cost of reducing traditional prerogatives of owners. Keynesian/Neoclassical answer

Your answer: B

The Austrian answer. http://www.mises.org/libprop.asp

You chose the Austrian Answer!

2. What is money and how does it originate?

A. Money can emerge from barter, but private interests will probably not develop it to suit the needs of a modern economy. We need central banks to sustain the financial sector. Efforts to manipulate the economy using the money supply will at best fail, and at worst cause severe problems. Monetary authorities should not increase the money supply at their discretion. They should increase it at a steady rate, matching the long term growth rate of the economy. Chicago answer.

B. Money is a vehicle for exploitation that distorts real values. Money is neither necessary nor desirable, but is an arbitrary artifact of history. Social progress will lead to revolutionary social changes, including the elimination of money. This will end exploitation and result in a society that aims at satisfying real values, instead of aiming at private financial profit. Socialist answer

C. Money always emerges out of barter. The difficulties of finding trading partners under barter systems results in the emergence of commodity monies. Durable, portable, and divisible commodities, like gold and silver, typically fit the bill as money best. Money and related institutions emerge as an unintended consequence of self interested trading. The evolution of such institutions is best left to the competitive market forces that created them in the first place, as governmental intervention will result in inflation and other distortions. Austrian answer. http://www.mises.org/rothbard/money.pdf

D. Money is a creature of the state. Sound monetary institutions require planning and a central bank. Central banks can also stabilize markets. Central bankers can counteract booms and busts in the private sector by expanding the money supply during recessions and slowing it during booms. Public control of the institution of money is key to running the economy. Keynesian/Neoclassical answer

Your answer: C

Austrian answer. http://www.mises.org/rothbard/money.pdf

You chose the Austrian Answer!

3. What is the proper method to conduct research in economic science?

A. The economist should not mimic the behavior of the natural scientists, because the social sciences involve human beings. Human action is characterized by intentional behavior, which involves the rational use of means to achieve desired ends. The very subject matter of economics—capital goods, money, wage rates, etc.—is not defined by physical or chemical properties, but instead by the mental or subjective attitudes that human minds take toward these things. Consequently, the proper method for an economist is to start with self-evident axioms—such as that people try to achieve the highest utility at the lowest cost—and logically deduce conclusions from them. The Austrian answer. http://www.mises.org/StudyGuideDisplay.asp?SubjID=3

B. Like the physicist, the economist (if he wants to be scientific) should construct a precise model that yields quantitative predictions about economic variables, such as GDP and unemployment. Then the economist should test those predictions against the actual data as collected by statistical researchers. At any given time, the best explanation or “theory” of a certain economic phenomenon is that model which yields the best fit between predictions and actual data. The Chicago answer

C. The question is misleading; economics cannot really be scientific in the conventional sense of the term. In physics we have fixed “laws” that are the same in every society and every time period. In contrast, there are no fixed laws in economics. The economist might study a certain historical episode and conclude that, say, rent control didn’t achieve its objectives when it was tried in Manhattan after World War II. Nonetheless, it may still be true that rent control could work in Paris in 2004 if the people in charge take care to avoid the mistakes of the past. There is no distinctly Keynesian answer; this is the position of the historical school.

D. To be scientific, we need to modify the traditional economistic approach of viewing society as nothing but a collection of atomistic, egoistic individuals. In reality, human beings consider themselves to be part of a greater social whole. A more fruitful avenue of research would be to study the complex groups with which people identify, whether class, race, or sex. Such an analysis would reveal the undeniable power of relationships in society, and give a much better understanding of economic events than typical, simplistic economic models. The socialist answer.

Your answer: A

The Austrian answer. http://www.mises.org/StudyGuideDisplay.asp?SubjID=3

You chose the Austrian Answer!

4. What is the reason for the interest rate, and should it be regulated?

A. Interest payments compensate investors for their loss of liquidity when they sink cash into a business project or lend it out for a certain period; the interest rate is the price of liquidity. Interest is a monetary phenomenon, not a “real” one (as the classical economists thought). Modern economics recognizes the role of expectations or what might generically be called “confidence in the future.” For example, if the interest rate jumps from 5% to 10%, this does not mean that people have become more oriented towards present consumption; it could simply reflect heightened anxiety about the economy. Government manipulation of the interest rate is certainly one of several tools needed to smooth economic fluctuations, but by itself this approach is relatively impotent. If everyone fears a worsening recession, employers will not hire more workers or build more factories, no matter how low the interest rate is pushed. Keynesian answer

B. Interest payments are a return on capital, and the interest rate in equilibrium equals the marginal product of capital. The situation is perfectly analogous to labor, where the wage rate equals the marginal product of labor. There are various technological recipes yielding output at various future dates, and consumers have preferences for consumption at various future dates. On the margin, present consumption will be preferred to future consumption, and an extra unit of capital invested will yield an increment in output (available in the future) that just makes the consumer indifferent between consuming now or waiting an additional unit of time and consuming the higher yield made possible by the productivity of capital. The government should not meddle with interest rates, for the same reasons that the government should not meddle with wage rates. Chicago answer

C. “Interest” is just a codeword for profit; a capitalist earns interest when he spends less on wages and raw materials than he earns from selling the final product. This surplus value arises from the exploited workers hired by the capitalist. Under the wage system, workers are paid the bare minimum they need to survive, even though the full product of their labor far exceeds their compensation from the employer. In this respect, the wage system is no different from traditional slavery, where the slave owner keeps the product yielded by his slaves’ toil, and from this fund only “pays” them enough to maintain their bare survival. Obviously interest is a barbaric feature of capitalist societies, and will disappear once the system of wage slavery is overturned. The socialist answer

D. Interest payments reflect the higher value of present goods over future goods. Other things equal, everyone wants to consume sooner rather than later. The current price of a computer might be $1,000, but the price of a claim to a computer delivered in one year would currently sell for less than that, say $900. An entrepreneur might invest $900 in labor and raw materials in order to sell a product next year for $1,000; his implicit interest return is due to the fact that the factors of production represent technological “claims” on future consumption goods, and thus their current price (the $900) is less than their ultimate sale price ($1,000). Obviously the government need not interfere with the market interest rate, since it merely reflects the subjective premium individuals place on a marginal present good over a marginal future good. The Austrian answer. http://www.mises.org/StudyGuideDisplay.asp?SubjID=10

Your answer: D

The Austrian answer. http://www.mises.org/StudyGuideDisplay.asp?SubjID=10

You chose the Austrian Answer!

5. What is the economic impact of saving?

A. In normal times, saving is not economically harmful but in a recessionary environment it can cause the economy to spiral downward. Saving reduces consumer spending and may not be translated into investment spending because of investor pessimism. This will reduce total demand in the economy and lead to unemployment. One way of

Keynesian/Neoclassical answer

B. The vast accumulation of wealth within select classes and families creates an economic oligarchy that shuts out those who cannot gain a foothold within the economic system. Inheritance taxes, and taxes on dividends, are essential to a society that values equality. After all, the yield from vast bank accounts really amounts to unearned income. No society can tolerate some people living off interest while others live paycheck-to-paycheck off the meager sums offered by minimum wages. Socialist answer

C. Saving (which means forestalling current consumption) is essential for capital formation, but there is no socially optimal ratio of consumption to saving that should predominate in society. It all depends on the social rate of time preference, that is, the extent to which people prefer goods sooner to later. Individuals may choose consumption over investment or vice-versa. Government intervention can skew these choices, subsidizing or taxing savings or consumption or both. In order to have the mix reflect the most economical choices, government should have no policy toward saving, even in the case of saving for old age. The Austrian answer. http://www.mises.org/humanaction/chap18sec9.asp

D. There is no investment, and hence no economic growth, without saving. For this reason, the encouragement of saving should be an economic priority. Inflation discourages savings, which is a major reason why a policy of stable money should be the central-banking policy. Empirical studies show that saving takes place over the life-cycle of individuals. Miscalculations can occur, which is why the government might need to encourage private retirement accounts, a system that is more efficient than Social Security because it yields higher returns. The Chicago answer.

Your answer: C

The Austrian answer. http://www.mises.org/humanaction/chap18sec9.asp

You chose the Austrian Answer!

6. What is the source of economic value?

A. Physical objects such as a banana or an automobile do not possess intrinsic economic value. On the contrary, only a human mind can attribute value to such items, and only then do economists classify them as goods. An object is valuable only because there is at least one human being who believes that this object can help satisfy his or her subjective desires. For example, even if a particular root cures cancer, if no one knows this fact, then the root has no economic value, and people will not trade money for it. Consequently, value is caused by an individual’s subjective desires and his or her beliefs about the causal properties of a particular item. The Austrian answer. http://www.mises.org/StudyGuideDisplay.asp?SubjID=4

B. The value of a commodity is equal to the amount of total labor used in its construction. If one bicycle has the same market value as, say, 500 eggs, then we can write 1 bicycle = 500 eggs. In what does this equality consist? Obviously the bicycle is not “equal” to the eggs because of any of its physical properties. If we examine the matter carefully, we will conclude that the one thing that the two have in common is the amount of labor used in their construction. The socialist answer.

C. The value of a good is determined by the interdependence of supply and demand, or what might be called the interaction of cost and utility. In contrast to some schools of thought, which try to explain value on the basis of utility alone, the correct approach is that of Alfred Marshall, who realized that economic value is due to both subjective preferences and to objective technological conditions. To see this most clearly, consider that if the costs of production go up for a particular good, in the new equilibrium its final price must be that much higher. Chicago answer

D. Economic value is a complex matter that cannot be explained through simple formulas. To understand why the people in a particular society value some things more than others, we must study their culture and history. For example, a Native American tribe might have valued a particular animal as sacred. The white Europeans, of course, did not share this value system and thus slaughtered the animals. The same is true of a good or service on the market. Historical School (there is no distinctly Keynesian answer to this question)

Your answer: C

Chicago answer

For optimal results the answer must be: A

The Austrian answer. http://www.mises.org/StudyGuideDisplay.asp?SubjID=4

7. What causes the business cycle?

A. Variations in the money supply cause GDP growth to deviate from its general trend. Absent these variations the economy is relatively stable. Variations in the money supply cause inflationary booms and crashes. Lags in the adjustment of wages with these cycles mean that financial booms and busts will entail significant changes in unemployment rates. Chicago answer

B. Competition in the face of declining profits and increasing monopolization generates increasingly large crises under capitalism. Capitalists invest in labor saving devices to keep unemployment high and wages down. Competition leads to falling profit rates and crashes. Some capitalists will then get good deals on capital from bankrupt capitalists, raising their profitability for the moment. However, the tendency of capitalism to reduce profit rates will lead to further unemployment and another crash. Socialist answer

C. Expansion of the money supply artificially reduces interest rates. This causes a boom in consumer and investor spending. With businesses thinking longer term, and consumer thinking shorter term, a discoordination emerges in the economy. The time relationship between saving and investment, production and consumption, is disrupted. Market processes reveal that many investments are not really profitable but instead are clusters of errors. Businesses then liquidate these investments, causing a recession. Austrian answer. http://www.mises.org/StudyGuideDisplay.asp?SubjID=12

D. Booms begin in excessive optimism, often prompted by technological shifts, resulting in speculative frenzies. Deficient total spending then causes recessions/depressions. When total savings exceed total investment, total spending on goods falls. This decreases the demand for labor to produce these goods. Then pessimism among business investors leads to insufficient aggregate demand and economic hard times. Keynesian/Neoclassical answer

Your answer: C

Austrian answer. http://www.mises.org/StudyGuideDisplay.asp?SubjID=12

You chose the Austrian Answer!

8. What causes economic growth?

A. A balanced relationship between aggregate demand and aggregate supply is the leading determinant of economic growth. Because private markets cannot always provide this, stable institutional environments are necessary. The public sector plays a vital role in securing economic growth by providing a framework of legal and financial institutions. A variety of public-sector efforts such as low-interest rates and subsidies may also play a positive role. A limited amount of regulation is necessary, but this is not necessarily true. Chicago answer

B. Private consumer demand is not enough for economic growth. Overall private spending is often too little, too manipulated by business, and rife with choices that overlook social priorities. Consumers may save too little or too much. This sometimes makes public deficit spending necessary to stimulate the economy. Also, private spending fails to supply public goods. Public spending in such areas is necessary for economic growth—particularly in education, infrastructure, and scientific research. Keynesian/Neoclassical answer

C. The capitalist process causes economic growth, but this is a non sequitur. While capitalism is the most productive system, the distribution of wealth under capitalism is wrong. Whole classes of citizens are left out. Capitalists take advantage of workers by paying them the lowest possible wage instead of the value of their labor. So capitalism delivers the goods, but to the wrong addresses. What we need are workers’ democracies where productivity can go hand-in-hand with a more just distribution of wealth. Socialist answer

D. The source of economic growth is mutually beneficial, voluntary exchange. Within the exchange economy, consumers spend part of their income on goods and services to satisfy their most immediate wants. This drives current production. Consumers save part of their income according to their less immediate wants. This drives entrepreneurial investment in future production and leads to the development of sophisticated capital markets. Private contracts, competition in markets, and private institutions that allow for capital investment and accumulation are all you need to attain optimal economic growth. Austrian answer. http://www.mises.org/journals/qjae/pdf/qjae2_2_5.pdf

Your answer: D

Austrian answer. http://www.mises.org/journals/qjae/pdf/qjae2_2_5.pdf

You chose the Austrian Answer!

9. Do markets create and sustain monopolies and what should be done about it?

A. If the history of capitalism shows us anything, it is that it leads to business concentration. With fewer and fewer firms dictating the terms, the result is ever higher prices combined with ever lower wages. Unions and antitrust enforcement have had some measure of success in curbing this, but neither institution goes far enough to counter the trend toward monopoly within market settings. We must also question the idea that competition itself should be a policy goal. Most often, it is socially wasteful and a slogan repeated by monopolists to justify exploitative behavior. The ideal of cooperation between all, a truly democratic economy, should be the ideal. Socialist answer

B. The market tends to generate monopolies of varying sizes and types. Business should not be permitted to exercise monopoly power in pricing. It can be detected by various formulas comparing costs with output price according to a perfectly competitive model. Geographic monopolies may not be as important as they once were due to advances in transportation technology. What we face today are a variety of technologically driven monopolies, such as the example of Microsoft shows. Still, regulators need to be constantly on the lookout for businesses that attempt to employ market power, enriching themselves at consumer expense. Competition needs rigorous enforcement. Keynesian/Neoclassical answer

C. Economists of the classical school were right to define a monopoly as a government-grant privilege, for gaining legal rights to be a preferred producer is the only way to maintain a monopoly in a market setting. Predatory pricing cannot be sustained over the long haul, and not even the attempt should be regretted since it is a great benefit to consumers. Attempted cartel-type behavior typically collapses, and where it does not, it serves a market function. The term “monopoly price” has no effective meaning in real market settings, which are not snapshots in time but processes of change. A market society needs no antitrust policy at all; indeed, the state is the very source of the remaining monopolies we see in education, law, courts, and other areas. Austrian answer. http://www.mises.org/StudyGuideDisplay.asp?SubjID=7

D. Monopoly regulation has caused more harm than good by protecting particular competitors, not competition. Some types of regulation against trusts are based on flawed models that fail to understand that some firms gain market share solely because of their products’ desirability to consumers. Most cited cases of “path dependency” turn out to be mythical. What is left for regulators to do? As Adam Smith said, they should prevent business conspiracy, blatantly predatory behavior, and otherwise assure a level playing field leading toward genuine competition. Finally, some goods lend themselves to being best provided by monopolies, e.g. courts and defense. Chicago answer

Your answer: C

Austrian answer. http://www.mises.org/StudyGuideDisplay.asp?SubjID=7

You chose the Austrian Answer!

10. What is the role of equality and inequality?

A. Equality is a term that properly relates to mathematics but not to social science. Human beings are unequal in their endowments, opportunities, and will to achieve. Unequal does not mean inferior or superior; it merely means different. Differences are the very source of the division of labor, and, within a market setting, lead not to conflict but cooperation. While differences should be celebrated, property owners have every right to treat people unequally because it is owners that bear responsibility. Legislators, however, should not have any concern for bringing about equality of result or opportunity, either between individuals or groups of individuals classified according to any criterion. The only place for equality concerns the law, which should treat all individuals the same without regard to their station in life. Austrian answer. http://www.mises.org/fipandol.asp

B. It is a great mistake to make equality of result a policy goal, because egalitarian legislation can kill incentives to improve. Punishing the rich is self defeating, even for the poor striving to make their way. Equality of opportunity, however, is something different. It something everyone merits by their very dignity as a human being. Thus should a nation strive for quality educational institutions, institute a limited inheritance tax, and otherwise assist those who, through no fault of their own, lack the means to gain entry into the division of labor. Once these institutions are in place, we will find that the forces of market competition will achieve egalitarian goals through predominately voluntary means. Chicago answer

C. Inequality is an intrinsic feature of a social structure that is mired in a prejudicial overhang from the long and shameful history of the manner in which Western society has treated women and other minorities. The prejudicial impulse, rooted in the spirit of conquest that gave birth to Western capitalism in the first place, is a form of violence and yet part of the corrupt infrastructure of the market economy itself. If the owners of capital were left to their own devices, excluded groups would remain so in perpetuity, so society had to act to restrain them. Full equality will continue to elude us, so long as we have a society that treats people as goods to be bought and sold, and so long as we make a god out of private property. Socialist answer

D. The modern emphasis on equality is the great policy advance of the last century. No longer does the political and economic system exclude women and minorities from participation but rathers include them as a matter of law. These groups tend to be artificially undervalued by the “invisible hand” of the market, which is why there is a role for anti-discrimination and public-accommodations law. The welfare state, too, has benefited society by insuring that the benefits of rising wealth are spread throughout society, so that the rich do not become richer at the expense of the poor. We’ve come a long way, but we still have a long way to go. Keynesian/Neoclassical answer

Your answer: A

Austrian answer. http://www.mises.org/fipandol.asp

You chose the Austrian Answer!

Well, I’m 95-percent “Austrian” according to my score on a 10-question quiz at the website of the Ludwig von Mises Institute.

The quiz is an education in itself. For each question, the quiz-taker must choose from among four detailed and sometimes subtly different answers: an Austrian School answer (10 points), a Chicago School answer (5 points), a Keynesian-Neoclassical School answer (2 points), and a Socialist answer (no points, though negative points would be more appropriate). I chose a Chicago School answer to one question and the Austrian School answer to the other nine questions. Thus my score of 95/100.

To see all 10 questions and answers, click here.

For a more arduous test of your economic philosophy, try the 25-question quiz.

UPDATED, 12/16/04 – 12/18/04

Earlier, I explained why privatizing Social Security makes economic sense. Now, Arnold Kling has an article (“Social Security’s Worn-Out Roof“) at Tech Central Station on the same subject:

Suppose that we want to reform Social Security so that your contributions go into a reserve account. One particular form that this reserve account could take would be a savings account in your name and under your control (within limits). That is called “privatization.”…

Your contributions that go into a reserve account cannot be used to pay benefits to current retirees. The government will have to borrow additional money in order to meet its obligations. However, by the same token, because of the reserve account, when you retire the government will not have to find as much money to pay for your benefits. The additional borrowing in the short term is like taking out a loan to repair [your] roof. But just as the new roof reduces future maintenance costs, putting your contributions into a reserve fund reduces the government’s future cost of providing Social Security benefits.

If “privatization” or a similar reform were to be enacted, the government would have to borrow more money.[*] That would be the “cash flow cost.” However, the economic cost is zero. The government is extinguishing an off-balance-sheet liability (unfunded promises to pay benefits) and creating an equivalent on-balance-sheet liability (new debt). To put it another way, the government’s “cash flow cost” incurred today will be offset by a “cash flow benefit” many years from now, as you receive lower tax-financed benefits and instead live off your reserve account. The net effect is essentially a wash….[**]

It is important to understand that, to a first approximation, there is no difference between maintaining the status quo and undertaking privatization that is financed entirely by borrowing. Either way, future generations have a liability.[***] Under the status quo, that liability is off the government’s balance sheet, like the dilapidated roof. Under privatization, the off-balance sheet liability is extinguished in exchange for debt that appears on the balance sheet.

As I have pointed out elsewhere, privatization financed by borrowing would have some advantages relative to the status quo. In particular, it would create a “lockbox” that would keep government from adding to the disconnect between its promises and the ability to find tax revenue to make good on those promises….

Precisely.

UPDATE:
I want to be clear that I’m not rescinding my earlier suggestion that the creation of private Social Security accounts would spur economic growth (see here, for example). With higher incomes, future taxpayers could more readily afford to bear the burden of supporting those retirees who remain somewhat dependent on Social Security.

I agree with Kling on two points: Privatization would take decisions about future benefits (and thus taxes) out of the government’s hands. Privatization is a “wash” to the extent that government borrowing to finance the transition to private accounts simply recognizes — and finances — future deficits.

I disagree with Kling that privatization is a wash when it comes to economic growth. Kling believes that the net economic stimulus from privatization is approximately zero because he subscribes to the crowding-out hypothesis: A dollar spent by the federal government is a dollar that can’t be spent in the private sector; in particular, a dollar borrowed by the federal government is a dollar that can’t be invested in growth-producing capital.

The crowding-out hypothesis, however, is based on a static analysis — a mere truism — which says that a given level of national output can be reallocated, but not changed. But the crowding-out hypothesis, which has reputable critics and doubters (see here, here, here, and here, for instance) doesn’t apply to a dynamic economy. The actual effect of government borrowing on interest rates — and thus on the cost of private capital formation — is minuscule, and perhaps nonexistent, as Brian S. Westbury explains:

The theory [that deficits drive up interest rates] suggests that deficits “crowd out” private investment, putting upward pressure on interest rates. In other words, government borrowing eats up the available pool of capital. But today’s forecasted deficits of $300 to $500 billion are just a small drop in the pool of global capital markets. In the U.S. alone, capital markets are $30 trillion dollars deep, for the world as a whole they approach $100 trillion. Deficits of the size projected in the years ahead cannot possibly have the impact on interest rates that many fear….

Our dynamic economy will take privatization for what it is: a continuation of consumption spending by retirees, legitimated by government borrowing, plus an infusion of new saving, generated by the diversion of Social Security taxes to private accounts. That infusion will spark new, growth-producing business investments, undeterred by vanishingly small increases in interest rates.

Privatization — no, the certain promise of privatization — will act as a spur to economic growth that wouldn’t have occurred otherwise. There is such a thing as a free lunch in aggregate economic activity.

As we know well from long experience, the course of the economy isn’t expressed by a smooth, upward rising curve of progress. Aggregate economic output can be thought of as a quantum phenomenon, in that it has many potential values at each point in time. Shocks and stimuli determine which of those potential values becomes reality. Shocks (e.g., the collapse of the American stock market in 1929) can lead to sharp and prolonged downturns that can be reversed only by strong stimuli (e.g., the mobilization for World War II). Despair feeds on itself, as does hope. And hope fuels the kind of creativity that we saw, for example, in the aftermath of the Civil War, when the rapid invention and adoption of new technologies and production processes took us to new heights of prosperity in the 1920s.

The same kind of creativity resurfaced in the late 1900s — spurred by the stimulus of an inflation-busting recession and significant cuts in marginal tax rates. Will it last? Will it take us to ever-higher levels of economic output? It might, but not as a matter of historical inevitability, as some suggest. Historical inevitability is what we see in the rear-view mirror of experience. Something must happen to spur the creation and adoption of new technologies that will take us to new economic heights.

There is no practical limit to human creativity: The greater the stimulus, the greater the response. Human creativity thrives on the stimulus of hope — hope that a better future is attainable and that those who help to create that better future will be amply rewarded. What better way to inject additional hope into the economic system than to fund capital markets?

Yes, that infusion would amount to a form of government intervention in the economy. But it would be — or could be — a relatively neutral form of intervention, as long as private accounts can be invested in total-market stock and bond index funds. Moreover, it would be intervention with a noble purpose: cleaning up the government-created mess known as Social Security. So, let the privatization of Social Security begin — and hope that it continues until the whole system is privatized.

In sum, the privatization of Social Security, in whole or in part, should have four beneficial effects:

• Future retirees will be more self-sufficient, thus reducing the burden on future taxpayers.

• The economy will grow more rapidly.

• Future taxpayers will therefore find it easier to bear the remaining burden of Social Security and other government programs.

• More Americans — perhaps the vast majority of them — will acquire a stake in free-market capitalism.

__________
My notes:

* Actually, as long as Social Security receipts from payroll taxes exceed benefits (until 2018), the government wouldn’t have to borrow all the money needed to cover benefits. It’s true that the government probably would use the surpluses to finance other government programs, so that diverting the surpluses to private accounts would require the government to borrow more in order to finance those other programs. But the real cause of the borrowing would be the existence of those other programs, not the privatization of Social Security.

** The “wash” is a wash with respect to the government’s true liabilities. But future retirees who invest in private accounts would be better off than if they opted for “traditional” Social Security.

*** Again, the unchanged liability is the amount of government debt. Meanwhile, Social Security (or at least a large portion of it) is in a “lockbox,” where it is invested in real assets, and thus contributing to economic growth, unlike government debt.