Quite a few of you responded to the two comments on Social Security a couple of weeks ago. One of the best and most straightforward questions came from James Griffin:

I wonder if you could give us some FACTS about how the current trust fund (ha!) is invested. I had thought the Gov issued some special IOU’s paying about 1%. However, some pundit stated in a recent news column that the fund was making 8%. At 8% we should be rolling in it? Yes? What is the real rate, if any?

There is good news, bad news, and good news — all of it rather important to understand.

The good news: Yes, Social Security is finally salting away some money as “reserves” for the looming Baby Boom generation. That money — about $70 billion this year alone — is invested in “special” Treasury securities of varying maturities that are actually special only in one important respect: the Trust Fund can redeem them “at par” — 100 cents on the dollar — any time it wants, to pay benefits. (That’s a nice feature. If you or I wanted to cash in long-term bonds early, at a time when interest rates had risen, we’d lose money, because they’d be selling at a discount.) As of the most recent annual report, issued in April 1996, the average interest being earned on the accumulated reserve was 7.8%. Since then, new funds have been invested at somewhat lower rates, because interest rates have fallen, so when the new report comes out in a few weeks, the average interest rate being earned by the whole pot might have slipped to around 7.5%.

I know that in a world of huge increases in the stock market each year, 7.5% must seem paltry, but actually — historically — it ain’t hay. The more typical, long-term return that can be expected from the stock market (dividends plus price appreciation) is around 9% or 10%, and there have been long periods when it’s been lower. (Did you know, for example, that the market was no higher in 1978 than it had been 14 years earlier?)

The bad news is that what you may have heard is true: when politicians talk about “balancing the budget” in 2002 (or whenever), they are including as “revenue” the excess Social Security taxes being set aside as reserves for the future. In other words, that money is being double counted. In 2002, if the budget does indeed “balance,” as Democrats and Republicans are using the term, it will still be in deficit by a projected $96 billion. (That’s the excess Social Security expects to collect in 2002 to augment its reserve.) So it won’t be balanced at all.

One can certainly get a bit hot under the collar at the lack of candor on this issue. I’m frankly surprised more hasn’t been made of it, except that I guess neither party feels it can convincingly blame the other for sweeping this under the rug.

The good news about the bad news is that impossibly large as these numbers are, viewed in context they’re actually not so bad. I know you’ll find that hard to believe, but bear with me a minute.

Let’s say we pretend to have a balanced budget but that, in fact, after being honest about Social Security, we’re actually running a $100 billion deficit, adding that much, year after year, to the national debt. Sounds awful.

But let’s say, also, that at the same time the economy is growing 5% a year — 2.5% inflation plus 2.5% real growth. What does that mean?

Well, it means that our national debt, $5.25 trillion or so now, would be growing by just under 2% a year ($100 billion is about 2% of $5 trillion), while the economy as a whole would be growing at 5%. And what does that mean?

Imagine a home you bought for $100,000 appreciating at 5% a year while the $80,000 mortgage you took to buy it grew at 2%. After 20 years, the home would be worth $265,000, while the mortgage would have grown to $119,000.

Naturally, it would be nice to have a house with no mortgage at all. But it’s a lot less nerve-wracking to have a $119,000 mortgage on a $265,000 home, I should think, than an $80,000 mortgage on a $100,000 home.

Run this out yet another 20 years and the home’s value is up to $703,000, while the mortgage is $177,000. A century later (just for the fun of it) — since one might imagine the U.S. economy really might be around a century from now, growing 5% a year, just as it was around a century ago — this hypothetical house would have grown in value to an astonishing $92 million, while the mortgage would be barely $1 million.

Really, when you think about it, so long as the debt is growing slower than the economy as a whole, it’s shrinking relative to the economy as a whole.

At the end of World War II, the National Debt was well over 120% as large as the Gross National Product (140% is the number that sticks in my mind). Then it got down as low as 30% or 40% (forgive me for not having the precise numbers at hand). Today it’s climbed back toward 70% . . . which is actually fairly low compared to most other nations. But the main thing is this: until recently, the annual budget deficit was so large, especially when reported honestly, without double-counting Social Security reserves, that the National Debt was actually growing faster than the economy as a whole. Big trouble. Lately, and even after admitting that the Social Security “reserves” should really not be counted as “revenue,” the National Debt has been growing slower than the economy as a whole. So we’ve begun the long, gradual process of shrinking the debt again.

That’s good.

Is it important to be “leaning against the wind” and, in all but recession years, have the debt gradually shrink relative to the size of the overall economy? I think so. Must it ever be paid off in full? Not really. Lots of healthy enterprises have some debt. Unless the U.S. economy is going to close up shop one day, it is perpetual, and can perpetually have some debt on its books.

So: it’s reasonable to be concerned and vigilant, but not necessary to panic. The sky is not falling.



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