First published here 7/6/2005
1. What do the Social Security trust funds consist of?
The Social Security trust funds are United States Treasury bonds. These bonds are issued by the U.S. Treasury to raise money to pay for budget deficits. The total value of all outstanding Treasury bonds is the national debt. The Social Security trust funds own part of the national debt.
The trust funds have been accumulating Treasury bonds since the mid-1980s because Congress, at the recommendation of Alan Greenspan and Ronald Reagan, decided to collect more in taxes than were needed to pay current benefits. That decision was made in order to build up reserves against the retirement of the baby boomers. As workers, baby boomers have been accumulating Treasury bonds to help pay for their retirement.
Figure 1 shows how the total national debt increased from March 1994 through March 2005 and who owns the Treasury bonds that constitute the national debt. The total national debt did not grow steadily over this period. In the seven years between 1994 and 2001, the national debt increased by a little more than a trillion dollars. In the four years since 2001, it has increased by two trillion dollars. When budget deficits were small or there were surpluses (as in the late 1990s), debt grew little. When they were large (as in recent years), total national debt rose rapidly.
In contrast to the growth of total national debt, between 1994 and 2005, the Social Security trust fund holdings of Treasury bonds (see the bottom segment of the bars in Figure 1) increased at a steady pace. But in spite of the steady increase in Social Security trust fund purchases of Treasury bonds, the trust funds still own less than a quarter of the total debt. Other federal agencies, and, in recent years, foreign central banks each own more of the debt than the Social Security trust funds. Private U.S. investors (pension funds, mutual funds, wealthy individuals), the owners of more than half of the debt in 1994, today own only 23 percent, about the same as the Social Security system. In recent years, Treasury bonds have not been an attractive investment for those with private wealth to invest.
2. How have we benefited from the Social Security trust funds?
To date, the Social Security trust funds have accumulated about $1.7 trillion worth of U.S. Treasury bonds. This means that the Treasury has had to borrow less from other lenders to finance our budget deficits. Consequently, the Treasury has not had to raise the rate of interest on its bonds to attract private investors, and it has had to rely less on foreign lenders such as the Central Banks of China and Japan. Private investors have put their saving into assets such as stocks, corporate bonds, and housing instead of Treasury bonds, which has led to construction of new buildings and purchases of new equipment in the United States, contributing to economic growth.
3. How secure are the Treasury bonds in the trust funds?
Any bond represents a promise by the borrower to pay the lender. In the past, some private borrowers and even nations have defaulted on their debts. Enron, Pan Am, Polaroid, and Bethlehem Steel went bankrupt. Debt issued by Argentina and Ecuador can be purchased for far less than its face value because many investors doubt that it will be repaid. And bonds issued by the Confederate States of America are suitable for framing, but for little else; they will never be repaid.
The United States, too, could default on its debt. The country could lose a war or a plague could decimate the population. Or our government could simply announce "We will no longer honor our promises to the Central Bank of China or the Federal Reserve Bank or the Social Security trust funds or anybody unlucky enough to have trusted us at our word."
How likely is it that the U.S. government would renege on its promises to its creditors? One way to determine the likelihood of such a thing happening is to see how Treasury promises are valued in financial markets. After all, debt issued by Argentina and Ecuador are available at fire sale prices in international financial markets. Is any debt issued by the U.S. Treasury similarly discounted? Absolutely not. Markets treat promises by the Treasury as essentially risk free. What is more, it would be quite impossible for the Treasury to announce "we are only defaulting on this portion of our national debt" without infecting all markets in which Treasury debt is sold. It is as if a person were to say "only my left leg has gangrene; the rest of me is fit and healthy."
The fact that a default on any part of the national debt is almost unthinkable is underlined by the reaction of financial markets when former Treasury Secretary Paul O'Neill and President Bush announced in speeches that the Social Security trust funds are nothing but paper. If markets really believed that the U.S. government would fail to redeem its bonds, there would have been an immediate rise in the risk premium on Treasury bonds, with interest rates spiking upward. But nothing happened. Everybody knows: it is only political talk.
4. Where will the money come from when the Treasury must redeem the bonds in the Social Security trust funds?
The U.S. government gets funds in three ways. It can look for increased revenues (through higher taxes). It can look to cut expenses (through lower spending). Or it can borrow by issuing new Treasury bonds. Replacing old bonds with new bonds is called "rolling over the debt," and it is done every day by households, businesses, and governments.
The ability of the government to service its obligations to the Social Security trust funds (that is, to future retirees) is inseparable from its ability to service the entire national debt. The question is not whether the Treasury will be able to repay the 22 percent of the national debt that is owed to the Social Security trust funds. The real question is whether the entire national debt, the sum of all the borrowing from all lenders, is getting out of control. Will the federal government be able to tax and borrow and scrimp in the future to meet its commitments?
One way to evaluate our nation's debt burden is to see what is happening to the size of the national debt relative to the nation's ability to pay. This ability to pay is closely tied to income, that is to the size of our national economy. Is our debt growing relative to our income? Figure 2 shows the answer to this question for the past half century.
The surprising message of Figure 2 is that every Democratic president (Kennedy-Johnson, Carter, and Clinton) left office with the ratio of national debt to income below where it was at the beginning of his administration, while the last three Republican administrations (Reagan, George H.W. Bush, and George W. Bush) have presided over explosive growth of the national debt relative to national income. Since 1960, Republican administrations have added 38 percentage points to the national debt/GDP ratio, while Democratic administrations have subtracted 23 percentage points from that ratio. This record stands on its head all the clichés about who is fiscally responsible.
Ultimately, the ability of the Treasury to keep its promises to pay bondholders what they are owed depends on government's ability to control its taxation and spending policies, in other words, to keep the entire national debt manageable relative to the size of the economy.
There is no special obligation or special problem posed by the Social Security trust funds. That debt is part of the national debt. The nation's ability to honor its commitments to its seniors is part of the larger effort to honor its commitments to all bondholders.
In historical perspective, the national debt relative to the nation's ability to pay is lower today than it was in the early 1950s (coming off the Second World War), but it is much higher than it was in the 1970s. Over the past three decades, Republican administrations have issued new debt much faster than the economy has grown. To meet its commitments to all its creditors, including the Social Security trust funds, future U.S. governments will have to control the fiscal policies that have produced such huge deficits-such rapid growth of the national debt. Will they? For the next few years, with the administration repeatedly asking for supplementary appropriations to fund the wars in Iraq and Afghanistan while striving to make the tax cuts permanent, it seems unlikely. Any decline in the national debt/GDP ratio would represent the first such decline under a Republican president since 1974.
There is no special problem of meeting the Treasury's obligations to the Social Security trust funds. The fundamental problem is the larger one of servicing the national debt. And the solution lies in controlling federal deficits.