How Social Security Fits Into Our Deficit/National Debt/Entitlement Spending Problem

There are so many crises today, it is hard to know which one to talk about.  There was the earthquake in New Zealand that killed 200.  Then came the earthquake and tsunami in Japan that killed 10,000 and threatened a disaster at the Fukushima nuclear power plant.  Then the war in Libya, with a policy that on the surface seems as simple as a game of tic-tac-toe, but underneath is as complicated as a Rubik’s Cube and with as much internal consistency as you would get from a Magic 8 Ball.

But I thought I would go back to the original American crisis:  Our deficit, our national debt, our runaway entitlement spending.  They are all part of the same problem, and it is only going to get worse if we don’t do something about it now.  The problem is the answers are hard enough that many politicians would prefer to kick it down the road, instead of trying to deal with it.  They justify their inaction by saying we have to focus on other more immediate problems first or by saying that they are certainly willing to talk about it and they are interested in hearing what the other side has to say (i.e., you first) or by just denying there is a problem. 

The Obama administration has used variations of all three responses to justify what some see as their lack of a credible policy on our deficit/national debt/entitlement spending problem.  When it comes to social security, their approach, at least recently, has been to deny that there is a problem.  For example, even though it is contrary to things he said in the late 1990s when he was in the Clinton administration, Jacob Lew, Director of the Office of Management and Budget, has recently denied that there is a problem with Social Security.  He says that the Social Security Trust Fund has enough money in it to last until 2037.  Mr. Lew’s statement is both literally true – and very misleading.  Let me explain. 

First, though it is obvious, it needs to be repeated whenever Social Security is discussed:  Social Security is a pay-as-you-go system.  The Social Security Administration takes the money it receives in taxes today and pays it out to people who have already retired.  Social Security does not put the money that is being paid in today aside for the retirement of the workers who are paying the money in.  There is no Social Security lockbox.  It’s just in one door and out the other.  Back when the Social Security Administration collected more money in taxes than it paid out in benefits,¹ Social Security “lent” this extra money to the Department of Treasury, i.e., the government, and Social Security got back an IOU² from Treasury.  The IOU was a promise by Treasury that, whenever the Social Security Administration needed the money, Treasury would pay it back to them.

Meanwhile, Treasury used the money it got from the Social Security Administration to pay the government’s other bills.  That meant, for example, during George W. Bush’s administration, when the government was spending more money than it collected in taxes, the government didn’t have to go out and borrow as much money as it would have otherwise had to borrow.  Which helped the national debt.  The national debt number that economists look at, and that politicians talk about, is the amount of debt that the government owes to outsiders; i.e., it does not include the debt that one part of the government owes to another part of the government.  It does not include, for example, the money the Treasury Department owes to the Social Security Administration.  Therefore, during the Bush Administration, the national debt was not going up as much, each year, as the amount of the deficit – because some of the deficit was being covered by the extra money the Social Security Administration was collecting and giving to Treasury. 

Let me give an example using simple numbers.³  Say that the deficit was $100 and that Social Security was collecting $20 more in Social Security taxes that it was paying out in benefits.  In that case, since the Social Security Administration lent (i.e., gave) that extra $20 to the Treasury Department, the national debt only went up by $80; i.e., the $100 deficit less the $20 in extra Social Security taxes that the Social Security Administration lent to Treasury.

That did several things.  By reducing the amount of money the government had to borrow from third parties, it reduced the government’s demand for money, which kept interest rates a little lower.  It also meant that there was less “crowding out” of private investment by the government’s demand for money.  The national debt went up less than it would otherwise have gone up.  And the interest that Treasury paid to the Social Security Administration on the money that Social Security lent to Treasury didn’t have to be actually paid in cash.  It was just an accounting entry. There was no real out-of-pocket expense, and it didn’t add to the deficit – or the national debt.

But now we are in a different situation.  Now we are paying out more in Social Security benefits than the Social Security Administration is collecting in taxes.  However, according to Jacob Lew, this is not a problem.  The U.S. government has a AAA rating, so the Social Security Administration can just ask Treasury to pay back some of the money that Social Security has lent to Treasury over the years, and Social Security will pay the benefits.  There is enough money in the “trust fund,” i.e., the Social Security Administration has lent so much money to Treasury over the years, that the Social Security Administration will not run out of money to pay benefits until 2037.⁴

But let’s look at today’s situation the way we did the situation in the Bush administration.  As I said, during the Bush administration, the Social Security Administration was collecting more in taxes than it was paying out, and it gave that money to the Treasury to use for other things.  Now we are in the reverse situation.  Now we are paying out more in Social Security benefits than we are collecting in Social Security taxes.  So Treasury has to pay back some of the money that the Social Security Administration has lent to it over the years.  Where does Treasury get that money?  Since there is no lock box, Treasury has to go out and borrow the money.⁵  Which means that, in addition to the money Treasury has to borrow to cover this year’s deficit, it also has to borrow even more money so it can repay the Social Security Administration.

Let me give an example using simple numbers again.³  Say the deficit is $250.  Say we are paying out $20 more in social security benefits than we are collecting in social security taxes,  Since Treasury has to go out and borrow the $20 that it needs to repay the Social Security Administration, that means Treasury has to borrow $270 from third parties, instead of just $250.

This does several things, most of which are the reverse of what happened before.   First, there is more “crowding out” of private investment by government borrowing than there would be if social security benefits and social security taxes were equal.  Second, to the extent that the government is borrowing even more money than the amount of the deficit, interest rates will probably be a little higher.  But the third thing is perhaps the biggest problem:  We have to borrow even more money from third parties than we would otherwise have had to borrow.  And the national debt is going up by more than the amount of the deficit, which is big enough by itself.

If you think that there will always be people willing to lend money to the U.S. government at reasonable interest rates and in the amounts the U.S. government needs to borrow, and that the amount of interest the U.S. government will have to pay in the future is not all that important, then there is no problem.

On other hand, if you are worried about the size of the national debt and about the amount of money we are borrowing from third parties, if you think there may be a limit to the amount third parties are willing to lend to the United States at reasonable interest rates, or that there may be a limit to how much third parties will lend to us at any interest rate, then this is a real problem.  Of course, the problem is not just Social Security, nor is Social Security even the biggest part of the problem.  The problem is that the federal government is spending way more money than it takes in, and the current administration doesn’t seem to have a realistic plan for getting this problem under control.  But while Social Security is not the biggest part of the problem, it is a part of the problem.  And it cannot be ignored on the grounds that there are bookkeeping entries somewhere that say there is enough money to pay full benefits for years.  Because the money isn’t there.  It was spent years ago, and now the government has to go out and try to borrow new money in order to pay these benefits.

The fact is that Social Security payments are adding to the amount of money that the U.S. government has to borrow, and as more and more baby boomers retire, the Social Security deficit; i.e., the amount of money Treasury has to borrow each year so the Social Security Administration can pay Social Security benefits, will increase.⁶

In the short run, there is not a lot we can do about the amount of money the Treasury Department has to borrow so it can repay the Social Security Administration and so the Social Security Administration can pay retirees.  And we can’t eliminate this amount in the long run, either – nor should we.  We made promises to people.  We can modify those promises around the edges, but that’s it.  We can push back the age at which people can retire and get full Social Security benefits.   We can also adjust how Social Security increases with the cost of living.  These changes will help, but they won’t mean that Social Security taxes will equal Social Security benefits again.  We have to realize that, for the foreseeable future, the amount of Social Security taxes collected is going to be less than Social Security benefits paid out, and Treasury is going to have to borrow the difference so that these benefits can be paid.

But there is one thing we can do:  We can acknowledge this situation, i.e., we can stop saying Social Security is not a problem because the trust fund will last until the 2030s.  And we can take this extra borrowing into account when we are determining what we need to do with our deficit and our national debt.  We need to realize that third parties, when they decide whether to lend money to the United States and how much interest to charge, are going to look at both the regular budget deficit and the amount Treasury has to borrow to repay the Social Security Administration.  That means that we need to reduce our budget deficit even more than we might have otherwise planned, so we can get control of our total borrowing requirements.  Because if we don’t control how much we borrow, our lenders may control it for us – by refusing to lend.⁷

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¹ As I will discuss below, this is no longer true.  Social Security is now paying out more than it takes in.

² Obviously, “IOU” is short for “I owe you”.  The reverse of IOU is UOI, which could stand for “Union of Idiots,” which seems like an appropriate name for those who think that Treasury will never have a problem borrowing money.

³ I am using simple numbers here to try to explain the problem more clearly.

⁴ Back in the 1990s, the Social Security Administration was supposedly not going to run out of money (under Jacob Lew’s theory) until 2046.  (See Paul Krugman, "Fiscal Poison Pill," The New York Times, June 16, 2008.)  Now the date is sometime in the 2030s.  Until recently it was thought that the Social Security Administration was going to be collecting more in taxes than it was paying out in benefits until 2016 (or so).  It has already happened.  In other words, the accuracy of estimates about Social Security funding leave something to be desired.

⁵ New Zealand, on the other hand, actually does have something very similar to a lock box.  New Zealand pays Social Security-like benefits out of general tax revenues; i.e., it does not have a separate tax for retirement benefits.  From an overall government revenue point of view, however, this is no different than what we are doing.  It is pay-as-you-go.  Except that about ten years ago, the Labour government saw that there was going to be a problem when the baby boomers hit retirement age.  So, the Minister of Finance, Michael Cullen, set up a special investment fund.  Each year the government put an amount of money into the fund and invested it.  The idea was that the money in the fund would then be available to help pay retirement benefits to the baby boomers when they retired.  It wouldn’t pay all of the benefits, but it would pay some of them, and it would reduce the amount that had to be paid out of tax revenues at the time.  We haven’t done that.  Instead of money in the bank, we have numbers on a page.

⁶ To get an idea of the size of the problem, let’s look at some real numbers.  In 2010, Social Security taxes were about $37 billion less than Social Security benefits paid to retirees.  According to Jacob Lew’s 2011 budget for the Obama administration, this number will be $56 billion this year.  While it will decrease back into the $30 to $40 billion range for a few years after that (assuming the economy picks up), it will start increasing again by the end of the decade and will be close to $100 billion by 2020.  While $100 billion doesn’t seem like a lot of money when the deficit is over $1.4 trillion, if you compare it to some of the deficits during the George W. Bush administration, it would have increased the total amount of annual borrowing by 25% to 30% or more.

⁷ Greg Mankiw wrote about what might happen someday if we don’t get our borrowing under control.  My only disagreement with his article is that I think he was too optimistic when he had it happening in 2026.  I am afraid it could happen before that.

P.S.  Unfortunately, this problem is NOT an April Fool's joke - except possibly on all of us if we don't address the problem of our deficit/national debt/entitlement spending really soon.