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January 15, 2005

The Battle for Social Security
by David Chapman

At an Economic Summit over December 15 and 16, President George W. Bush unveiled a plan to privatize Social Security. It was not the first time that this plan has been mentioned but it set the tone for what is to be a legacy issue for Bush's second term in office. It also set off a fire storm of controversy.

The contention is that the current system as it is administered will be bankrupt by 2042 if drastic action is not taken. Indeed in a recent speech Bush emphasized the word bankrupt 5 times to get the point across and in saying that payouts will start to exceed contributions by 2018 and be bankrupt by 2042 and therefore workers would get nothing (If that were the case it would effectively be a default by the Government of the United States). Indeed the way it was put suggested that the current social security system is nothing more than a pile of worthless IOU's. If the Social Security trust is worthless what does that say about the $4.3 trillion of debt held by bond holders. Is it worthless too?

The drastic action being proposed is that people have upwards of 4% of their payroll tax contributions diverted into private accounts. In order to help balance the diversion of funds to the private sector it may be necessary to cut benefits or raise payroll taxes both of which have been rejected by the Bush White House. As well current retirees would not be impacted nor would current workers by any cut in their current benefits.

The idea has been around for quite some time although critics do point out that one has the ability to run a private retirement fund through 401K plans, 403b plans and IRA's (and here in Canada through Registered Retirement Savings Plans (RRSP)). Of course such a huge diversion of funds in the stock market would be a dream for the banks and investment dealers that would be the beneficiaries of the fund flows and would of course benefit hugely from the fees generated to manage the funds. The financial community is therefore the biggest booster of the plan as are many economists.

Opponents of course point out a number of things they believe are wrong with the plan. Most agree that in present value terms Social Security promises for pension payments exceed revenues by some $4 trillion over the next 75 years. But they also point out that the shortfall makes up less than 1% of income (and under .5% according to the Congressional Budget Office) over the next 75 years. Therefore the current system does not need this radical reworking but it does need some adjustments. By contrast the more recent promises of Medicare drug benefits that the Bush administration pushed through Congress is estimated to add $6 to $8 trillion to Medicare costs over the next 75 years. The Bush administration's tax cuts that they are making permanent will cost even more.

Further the opponents point out the diversion of the funds would create a permanent hole in Social Security and require borrowings in the area of $1.5 to $2 trillion over the next ten years. Unfunded liabilities would be wiped out but the current deficit of over $400 billion annually would rise sharply. The US Government has been borrowing funds from Social Security for years to pay for deficits (or as some say pilfering Social Security to pay today's bills). Today the deficit sits at 4% of GDP and rising and the proposed diversion would add upwards of another 1-1.5% of GDP every year to the debt. The current total debt of some $4.3 trillion would rise sharply as additional borrowings would be required to finance the diversion of funds. Of course supporters say that shortfalls would be made up by budget cuts elsewhere, higher returns on investment and higher economic growth.

Oddly the economic forecasts of growth for the current social security method is gloomy but divert the funds into private funds and suddenly the forecasts become very rosy. As well given the costs of the military and the fact that instead of cuts Congress handed out more pork adding billions to the already bloated deficit then the solution being proposed is, it could be argued, so much hot air. America is already deeply divided by religion, the War in Iraq (where the raison d'etre for the war - that there were no Weapons of Mass Destruction and now the search has been completely abandoned with nothing turning up) and other moral issues. So to add another deeply divisive issue that clearly would be very costly to make up the diversion of funds seems to be overkill.

Another issue opponents point out is that even diverting the funds to private plans there is no guarantee that the plan would be able to deliver the gains that it says it will. An earlier similar private plan in Chile under the disgraced dictator Augusto Pinochet ended in disaster for thousands of retirees who are effectively getting nothing while some benefits are flowing to those that least need it. Chile is reverting to a public social security system after the earlier disaster. Many investors have seen their 401K plans and IRA's decline sharply in value following the bursting of the tech bubble in 2000. Today we sit on edge of another stock market bubble plus a bubble in the housing market financed with mortgages often 100% or more of the value of the house on floating rate debt that is vulnerable to rising interest rates.

With a possible diversion of 4% of current payroll taxes being diverted to private funds there are proponents in Congress that want to divert up to half of payroll tax contributions and guarantee that current benefits would not be cut and taxes would not go up. If 4% was $1.5-$2 trillion over the next ten years the cost of that diversion that size would be an even more astronomical $19-$25 trillion in the same ten year period. Instead of the bankruptcy of the social security system in 2042 they would be talking about the bankruptcy of the US in less than 10 years. Worse the proponents of these plans don't even want to count the borrowings for funds diverted for social security in the normal budget deficit. Instead it would be off the balance sheet. (Do we hear the word "Enron")?

While the opponents of this plan have come from numerous sources many of which are the usual opponents to the Bush administration one of the most telling critics is The Economist who has cited the fallacies of the plan in articles on December 9, 2004 and again on January 8, 2005. It promises to be quite the battle but given Bush's control of both Congress and the Senate it is expected to pass easily.

If the opponent's numbers are correct then the massive deficits of the US promise to become even more massive. The massive deficits of budget and trade are already becoming astronomical. If the US were any other country the IMF would already be calling and a major devaluation of the currency would be underway. But we have cited that what is going on is system of mutually assured destruction with foreign countries purchasing US debt in order to prevent their own currencies from rising too fast and impacting their export industries. This of course is very similar to the "beggar thy neighbour" policies of the 1930's that contributed to the Great Depression.

The fact that a major financial crisis has not as yet happened is no reason for complacency on anyone's part. The games life is getting shorter but even we admit it could still have another year or so left but time is running out. If the social security diversion gets underway its life could become even that much shorter. Some opponents consider this a great line in the sand that if does happen will guarantee the bankruptcy of America. Strong words but the reality is at the moment the rosy forecasts on one side are offset by the gloomy forecasts on the other and they are just that at the moment - forecasts.

Since the world came off the gold standard in 1971 there has been three great devaluations of the US$. The first one lasted from 1971 to 1980 and saw the dollar lose over 50%. The second lasted from 1985 to 1991 or 1995 for the double bottom losing again over 50% in the period. The third great devaluation got under way with the top in 2001 and since then the US Dollar has fallen roughly 33%. A 50% decline, which is the minimum of the last two great devaluations, would take the US Dollar down to around 60 from the current 83.

Over the past few weeks the US Dollar has rebounded from its lows. Many have crowed that the US$ fall is over and we should embark on a new era of a strengthening US$. More modest forecasts are saying that a US$ recovery could last the better part of the year. Certainly our long chart of the US$ index indicates that we could rally up to 85 to 87 and still remain in the bear channel that has been in place over the past three plus years. But to believe that the long decline of the US$ is over one would have to believe that the US deficits are coming to an end and that the US is about to embark on a new era of economic expansion.

Of course that is just wishful thinking. The US is now running the biggest deficits in world history. Yet this myth persists that just because the US is the world's biggest economy and that they are also the world's reserve currency at the end of the day everything will work out fine and we will avoid the economic collapse and Armageddon that some of us have been calling for now for years. The admission that Social Security is bankrupt and that they may have to default is a scary proposition. Investors should be very wary especially if this battle for Social Security is won by those wishing to go the privatization route.

For those who believe that the US would never default one only has to hearken back to when the gold standard was ended in August 1971. At the time the US$ was supposedly convertible into gold. Of course the ability for all the US$ floating around the world at the time to be converted into gold was impossible at the time (estimated to be around 20% at the time). So the end of the gold standard was effectively a default. Could Social Security be the next big default?

DavidChapman.com
Technical Scoop

Charts and technical commentary by:
David Chapman of Union Securities Ltd.,
69 Yonge Street, Suite 600,
Toronto, Ontario, M5E 1K3
(416) 604-0533
(416) 604-0557 (fax)
1-888-298-7405 (toll free)

David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund www.bmsinc.ca

Note: The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete.

The information in this report is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does Union Securities Ltd. assume any responsibility or liability. Estimates and projections contained herein are Union's own or obtained from our consultants. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any securities and is intended for distribution only in those jurisdictions where Union Securities Ltd. is registered as an advisor or a dealer in securities. This research material is approved by Union Securities (International) Ltd. which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the U.K. The investments or investment services, which are the subject of this research material are not available for private customers as defined by the Financial Services Authority. Union Securities Ltd. is a controlling shareholder of Union Securities (International) Ltd. and the latter acts as an introducing broker to the former. This report is not intended for, nor should it be distributed to, any persons residing in the USA. The inventories of Union Securities Ltd., Union Securities (International) Ltd. their affiliated companies and the holdings of their respective directors and officers and companies with which they are associated have, or may have, a position or holding in, or may affect transactions in the investments concerned, or related investments. Union Securities Ltd. is a member of the Canadian Investment Protection Fund and the Investment Dealers Association of Canada. Union Securities (International) Ltd. is authorized and regulated by the Financial Services Authority of the U.K.

Copyright © 2002-2008 David Chapman

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