Reality Ten: It Can Get Worse.

Social Security Reform: Flows Matter.  

The last posting, “Reality Nine: Class and Age: Marxis Dead, Bury Him,” started with the statement:  “A key element of many Marxist’s (and liberal’s) thinking is a conflict between workers and capitalists…. At its extreme (among some Europeans and in Social Security), the pursuit of the conflict has been carried to the point of cutting-off-your-nose-to-spite-your-face.  They treat working as if being employed were antisocial (e.g., the displacing workers nonsense in the last posting).  But, that’s a side issue for another day or a different posting. The point is: anyone who is retired is living off of capital.”  This is that “another day.”

There is one of those inconvenient truths haunting the Social Security discussions.  It concerns the interaction between capital and labor.  Interestingly, many social scientists (including, most disgracefully, economists) address the issue with an apparent total ignorance of both the techniques of their discipline and the implications of those techniques. 

If quantitatively inclined, one can easily get lost in issues surrounding multivariate analysis, the aggregate production function, lag structures, multifactor productivity, and complexities surrounding variable interaction.  However, it’s easy to cut through the clutter.  Without getting into the details, it’s a simple concept to understand.  It can be illustrated with a simple saying: “One can’t drive many nails without a hammer, but a hammer doesn’t drive many nails by itself.”

The implications for discussions surrounding Social Security are stark.  To facilitate an appreciation of just how stark, let’s assume away all issues related to the relative effectiveness of public sector investment verses private sector investment.   That should eliminate a lot of the political rhetoric.  Granted, the efficient use of capital is important, but any increase or decrease in the efficiency of capital’s deployment is being overwhelmed by changes in the flow.  Put differently, we are disinvesting (liquidating capital) so fast and at such levels that any change in efficiency doesn’t make that big a difference. 

For example, consumer sector debt has an unsustainable upward trend.  What’s even worse, it has grown most among people least able to manage it.  People get credit cards before they have established a savings account.   They take on mortgages with no equity, basically renting money instead of renting without the long term liability.  They borrow in order to buy depreciating assets.  What’s astounding is that people who have previously displayed the ability to manage debt are imitating this financial mismanagement.

Granted, consumer debt is an asset from the lender’s perspective.  The lender owns a claim on an income stream, usually a bond.  However, as was unavoidably apparent during the financial crisis, the asset was not backed by a reliable claim on equity in an output-producing item.  The loan didn’t contribute to the stream of goods and services available.  In instances were one could argue that there was a real asset, new housing stock for example, the value of the future ability to house people was far less than the amount of the loan.

The US public sector is compounding the problem by pursuing the same strategy.  We’re imitating the Greeks and their fellow Europeans.  Of course, being Americans, we’ll do it bigger and better.  Interestingly, our government has discovered the trick to annuitizing capital thus making the liquidation that much harder to stop.  While the exact numbers are debatable, Dennis Cauchon of USA TODAY provides a telling calculation.  In “Federal Deficit Dwarfs Official Tally” he reports an estimate that the “Federal debt and retiree commitments equal $561,254 per household.”  That’s quite different from the official numbers reported by the government.

He goes on to explain why the half a million plus per household is a more honest estimate:  “The big difference between the official deficit and standard accounting: Congress exempts itself from including the cost of promised retirement benefits. Yet companies, states and local governments must include retirement commitments in financial statements, as required by federal law and private boards that set accounting rules.”

“The deficit was $5 trillion last year under those rules. The official number was $1.3 trillion. Liabilities for Social Security, Medicare and other retirement programs rose by $3.7 trillion in 2011, according to government actuaries….”

As if a government annuitizing whatever capital it can get out of the public isn’t bad enough, the rate at which they’re doing it is both astounding and accelerating.  For example, the article notes that under honest accounting practices, “the government ran red ink last year equal to $42,054 per household ….”

Put in plain terms, the government used capital at a rate that darn near equaled all of household income.  Figuring in the tax bite on households, one has to wonder how government officials can fail to understand why households are struggling.

As we deplete our capital stock, the productivity of labor falls.  That lost output is in addition to the direct loss attributable to the smaller capital stock.  It is the reduced labor productivity as workers have fewer “tools” to work with.  With fewer tool, the worker produces less. Since less is produced, incomes fall. In order to protect current consumption levels, which many citizens and politicians confuse with living standards, we consume more of our capital. 

So far, however, the focus has been on financial indicators of physical capital.  Yet, we know output is the result of multiple factors, not just physical capital.  Human capital is one of the terms used to refer to the skills and education.  It’s convenient since it conveys the idea that human capital is created as the result of purposeful effort.   However, the notion that education measures human capital is suspiciously self-serving when advanced by educators.  It’s particularly suspect when viewed against a longer history.  Yet, it could well be true of modern economies.  So, let’s consider it a viable issue.

Historically education made a major contribution to creating some basic social norms that represent major forms of human capital.  In development economics, there is a greater appreciation for things like regularly showing up, developing self-control, sticking to purposeful activities, listening to instructions, measuring performance based on criteria other than one’s own personal whim, recognizing the future consequences of actions and decisions, and accepting classroom/community standards for behavior.  When those “skills” are absent, the quality of human capital suffers. 

Despite the role education can play, education is far too broad a topic to treat as a uniform ingredient.  One doesn’t have to look beyond the occupants of some of the tents of the “occupy” movement to sense that we’ve educated some people in the fine art of contributing less to society then if they never went to school.  The truth is education contains a large component of consumption as well as investment.  Learning can be, and often is, great fun. 

In response, some observers focus on disciplines, as in the frequent lament that the US graduates too few scientists, mathematicians, and engineers.  Others focus on some other pet topics: prayer, classroom size, military training (ROTC for example), research, or the silliest of all, funding levels.  Depending on what ax one wants to grind, it’s always possible to find some spurious correlation to support one’s position.  Without agreement on what education is supposed to accomplish, the debate goes nowhere.

Fortunately, when the issue is human capital as a factor of production (i.e., something that contributes to the ability to feed, clothe, and house oneself; basically support one’s own consumption) the issue is simpler.  Once the criterion is clear, it is possible to establish clear measurement of results. For example, Chinese government funds for education are expected to improve employability.   If the education doesn’t result in a target level of employment upon graduation, government funding is reallocated to different programs.

For better or worse, we seem to have decided that preparing people to provide for themselves isn’t the role of education.  It’s as if we are afraid that preparing people to provide for themselves implies a value judgment we aren’t willing to make.  Understand this is a very different issue from the “scientist, engineer, prayer, classroom size, military training (ROTC for example), research and funding levels debate.”  It’s very fundamental.  More oriented toward whether we are teaching basics like “regularly showing up, developing self-control, sticking to purposeful activities, listening to instructions, measuring performance based on criteria other than one’s own personal whim, recognizing the future consequences of actions and decisions, and accepting classroom/community standard for behavior.”

If you think it is phony issue, a red herring, consider these facts.   A person can virtually assure that they and their family will avoid poverty by accomplishing three simple goals.  The goals are (1) complete at least a high school education, (2) work full time, and (3) wait until age 21 before getting married and having a baby.  Census data shows that people who followed all three of these rules had only a 2% chance of being in poverty and a 72% chance of joining the middle class (defined as above $55,000 in 2010). These numbers were almost precisely reversed for people who violated all three rules.  Ignorance of these basic principles (or ignoring them) raised the chance of being poor to 77% and reduced their chance of making the middle class to 4%. 

This simple recital of Census data is confirmed by extensive social science research.   It isn’t ideological.  One can find serious social scientists from libertarians to liberals who only differ in interpretation and prescribed responses, although each will add his or her pet items to the list.  From the perspective of human capital, the facts leave little doubt that continued poverty in the US is the result of a failure to teach some basic life skills.  

So, neither human capital nor physical capital is being added at a pace that can support Social Security through the twenty-first century.  By contrast, it is very reasonable to argue that historically Social Security succeeded during a period when the US was expanding both its human and physical capital.  The issue isn’t really whether the capital stock is large enough.  The issue is whether Social Security can succeed when the capital stock is shrinking.  The unfortunate answer is: Yes, if your time horizon is an election cycle, and no, if your time horizon is the life expectance of an average American.