Trust Fund Redux: A Parable

Consider this story of two friends, George and John. Every evening after work the two meet at a corner tavern to have a beer, and then each goes home to his family.

But last evening George showed up without his wallet, and so needed to borrow the cost of his beer from John. "I'll pay you back tomorrow," said George. So John lent him the money.

This evening, knowing that George would be repaying his loan, John arrived without his own wallet. But as bad luck would have it, George had once again forgotten his wallet as well. Neither man had any money on hand.

George knew that he had promised to repay last night's loan from John. And he also thought he'd like to enjoy a beer himself this evening. What to do? Luckily, George spied a friend, Dick, across the room. George asked Dick to loan him the money to buy himself a beer. "And John doesn't have any money either," said George. "Could you loan me the money for his beer too?"

Question: What's wrong with this story?

Answer: What's wrong is that George told Dick that he's borrowing money for a beer for himself and a beer for John. That is false. George is actually borrowing the money for his own two beers: the one he wishes to drink tonight, and the one he drank last night. Remember: last night's beer was paid for by borrowing from John. George is actually borrowing from Dick to repay John, as he promised he would, and John will do with the money whatever he wishes. Probably he will buy himself a beer.

Is this an important distinction? You bet it is. George has chosen to engage in a bit of "deficit spending," knowing full well he'd have to repay the loan. When he pays off his debt, he's paying for the beer he chose to drink at a time when he didn't have the funds to pay for it. Of course, in this example George has paid his debt to John by borrowing from Dick, and with tonight's beer George is now in debt for two beers. George's borrowing could continue in this manner for some time, but one presumes that eventually he will need to come up with the funds to pay off all his debts.

This little parable is quite useful in understanding the present situation with the Social Security trust fund. We all know that the U.S. Government has been engaging in deficit spending for a long time. And everybody believes that, one way or another, the government will make good on its debt. (If everybody did not believe that, then the world financial markets would collapse immediately.)

Now it turns out that one of the government's creditors is the Social Security trust fund, which has been running large surpluses for the past couple of decades and thus has money to invest. It has invested that money by loaning it to the government. That is, the government has been borrowing from the trust fund, in addition to borrowing from the public through the sale of bonds*.

Some critics see this government borrowing as a "looting" of Social Security. They say it amounts to the government writing "worthless IOUs" to itself. When it finally comes time to use the trust fund for its intended purpose—to pay Social Security benefits—we will find to our horror that the money has already been spent. So say the critics. At that point we will have two choices: we can default on our obligations to pay Social Security benefits, or we can somehow raise the necessary funds—by borrowing or by taxing—to pay them.

Now here's the important point: critics say when we raise revenue (ultimately through taxation) to pay Social Security benefits, then we're paying for those benefits twice: once through the initial payroll taxes which were supposed to build up the trust fund in the first place, and then again by more taxes when we find the fund has been looted.

The critics are wrong.

Let's be clear. When we finally get around to repaying our obligations to the trust fund, we'll not be raising money to pay Social Security benefits; we'll be raising it to pay for whatever we spent the money on when we borrowed it in the first place.

A useful example is the Iraq war. Since it is very expensive (in the many hundreds of billions of dollars), and since the government is running huge budget deficits, no one can dispute that we're financing the war through deficit spending. That means the war has not yet been paid for. "Settling up" for the war's costs is something that will happen at some point in the future. We may even delay the inevitable somewhat longer by borrowing yet again (as George borrowed from Dick), this time to pay off our initial war creditors. As long as someone is willing to loan us money, such borrowing can go on indefinitely.

As a major creditor to the government, the Social Security trust fund has certainly loaned a lot of money to cover war expenses. When the trust fund is needed to pay benefits, what shall we say? That we need to find the money to pay benefits to retirees? Of course not. The truth is that we need to find the money to pay our war (and other) debts. As those debts are paid, the trust fund will have the assets it needs to pay benefits. It's the same as with George and John: In paying back John, George is actually paying for his own beer that he financed with deficit spending—not buying John's.

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*Actually, the government loans money to the trust fund in exactly the same way as it loans to the public: by issuing bonds. As with the government's other creditors, the trust fund holds interest bearing U.S. government bonds. And why not? U.S. government debt is regarded as among the safest investments in the world. With regard to the bonds it holds, there is no material difference between the trust fund and the government's other creditors. Indeed, the trust fund's holdings are listed as part of the overall national debt alongside those of pension plans, sovereign wealth funds, and individual bondholders (all but the trust fund being described as debt held by the "public").

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The first part of this article's title follows from the fact that I have previously posted a more expansive discussion of the trust fund. Today's piece focuses on an argument for trust fund solvency which is both simple and intellectually honest, but which nevertheless seems to have been widely overlooked.

Copyright (C) 2005 James Michael Brennan, All Rights Reserved