The Social Security Mess

A consensus exists among economists across the ideological spectrum on at least one important issue: America's entitlement spending -- mostly Social Security and Medicare -- is not sustainable. And neither political party is willing to talk about what needs to be done to fix the situation.

Young Peter Pays for Old Paul
The economics of entitlements are fairly straightforward, even if the politics are nearly impossible. We have promised benefits in the future that we won't be able to afford, at least not without some major changes to the system.

Have you seen all the headlines about struggling pension plans and burgeoning health-care costs for retirees? The mother of all pension plans is Social Security, and the biggest health-care program for old people is Medicare. Taxpayers pay for both of them. But the problem is that we're living longer. That changes the finances of any program that promises benefits until you die. Meanwhile, we're having smaller families -- this means fewer younger workers to support every elderly beneficiary.

Unlike private pensions, Medicare and Social Security have no "savings" component. If you're currently working, your payroll taxes are not tucked into some account with your name on it. They go to pay the benefits of current retirees -- young Peter pays for the Medicare and Social Security of old Paul. When my brother's father in law needs open heart surgery or additioanl prescription anti-cholesterol drugs because he ate a bucket of fried chicken, all of you paid for those treatments. My brother thanks you.

Our entitlement programs are basically a pyramid scheme, and, like any good pyramid scheme, it works fine as long as there are enough workers on the bottom to continue paying the retirees at the top. Those days are rapidly coming to an end, however. In 1960, there were five workers for every retiree. Now, there are around three. By 2030, there will be two.

Death Is the Low-Cost Option
Meanwhile, the Baby Boomers will soon be breaking their hips and suffering other expensive infirmities. Demographers like to point out that Bill Clinton (born Aug. 19, 1946) represents the leading edge of the Baby Boomers. You may recall that he just had open-heart surgery.
It's not just heart surgery, of course. Medical technology has given us a whole new set of expensive things that we can do to improve our health in old age. It used to be that when Aunt Bee injured herself playing shuffleboard, she'd have to tough out the pain. Now we can replace her knee.

That's good, but it's not cheap. Indeed, death is the low-cost option. Every time you patch someone up and send them back to the shuffleboard court, you merely ensure that they will return later with some other malady. Everybody dies of something -- and it can be cheaper for the government if you do it sooner rather than later.

In 2000, Philip Morris had the bad taste to make this point explicitly while the Czech Parliament was considering higher cigarette taxes. The tobacco giant commissioned a report pointing out that premature deaths from smoking saved the Czech government millions of dollars a year in pension and old-age housing benefits.

Hapless Politicians
All economists recognize that some combination of four things is necessary to make the entitlement equation balance:

1. Cut benefits for retirees.
2. Raise taxes on workers.
3. Allow more young immigrants into the U.S. who will begin paying taxes into the system.
4. Make workers so much more productive that existing tax rates will generate enough new revenue to fund the extra burden of an aging population. (This option would be great, but we have no idea how to accomplish this.)

The Democrats are dreaming if they think it's possible to make entitlement programs solvent in the long run without cutting benefits. The logical place to start is by moving more aggressively to raise the retirement age to reflect the reality that we're all living longer.

That's politically tough, but it pales compared to the decisions we may have to make on the Medicare side. Someone may have to tell grandma that she doesn't get open heart surgery -- or at least that Medicare won't pay for it. And while we're having that discussion, we may have to broach the subject of grandpa's Viagra.

We may need tax increases, too, which the Republicans will hear none of. The more egregious error on that side of the aisle, however, was in completely confusing the Social Security issue during the debate over privatization. Nothing is inherently wrong with private retirement accounts if the system is designed responsibly. It solves the demographic problem once and for all by having every worker fund his or her own retirement benefits.

But privatization proponents completely papered over the enormous transition problem. If young Peter starts funding his own private retirement account rather than paying payroll taxes, then who pays old Paul's retirement benefits? Remember, it's a pyramid scheme, so someone has to keep paying the people at the top.

Washington seems to be marching in exactly the opposite direction.
The new Medicare prescription-drug plan adds another layer of entitlement spending -- which would be fine if we had figured out a way to pay for the promises we've already made. So far, we haven't.