Saturday, December 11, 2004

Mike Davis has some good points. That, and a free money machine

Wouldn’t it be awesome if my great-great-grandfather (Giocchino Tomasello) had invested some money away for my retirement? I’d be like a millionaire! With that much money I could squirrel away a bunch of money for my great-great-grandson. Obviously, this speculation isn’t really that useful because, without money, there’s no obvious way I can go about becoming a millionaire. Certainly borrowing is out of the question!

It would be better if instead of paying for the current retirees, each generation invested their money for their own. That way the money would sit around for 40 years and gain interest. But then, I suppose it would be even better for the money to sit around two generations and gain even more interest! In this much I can agree with Mike when he suggests that we try to move to a system where people’s money sit around gaining interest instead of the one we have now. The problem is getting there while in debt. Republicans suggest we borrow money.

Mike Davis says “in any 30 span of history you care to look at, a total stock market fund significantly out performs the government mandated interest payments on a person’s contribution to SS”. Mike, along with Republican law-makers, leads us to draw the conclusion that investing the money in stocks would be better than the system we have now. This seems obvious! Why is it that this obvious conclusion indicates that the Republicans have a magical enchanted system for producing absolutely 100% free money? It takes a little bit of economics to explain:

How do government bond interest rates get set? The answer is those infamous “invisible hands”. The government wants you to buy its bonds so it can make money. It goes out and offers the lowest interest rates investors will put up with. Bamn! Capitalism is awesome.

Now, the Republican federal deficit is growing every year. So, if you wanted to take money out of SS to put into stocks while maintaining benefits, you’d have to raise the money through selling bonds (mostly to China). So really, it’s only going to save us money if stocks do better than bonds.

Until recently investors seemed to habitually undervalue stocks in favor of bonds. This looks like a good old-fashioned market inefficiency. We could take advantage of that. The problem is that market inefficiencies tend not to last too long after they’ve been caught. As soon as people realize that stocks are better than bonds, the government finds it has to offer higher interest bonds to entice people to buy. Meanwhile, stocks get more expensive as stock buyers have to compete with all those guys who used to foolishly stuff their money into bonds. There are a lot of indications that this switch has already happed: stocks price to earning’s ratios have gotten a lot higher in recent years.

To believe that we can make money by switching to stocks you’ve got to believe that the market inefficiency is going to persist. That no one who buys bonds is going to decide to go into stocks instead. If you believe that then you can create 100% free money as follows:

  1. Have the government raise one trillion dollars through the sale of bonds
  2. Invest the one trillion dollars in the stock market
  3. Wait
  4. Sell all the stocks
  5. Buy back the bonds.
  6. Count your free money. On average it should be equal to $1,000,000,000,000 * (stock rate of return – bond rate of return) * time you waited

Indeed, the whole plan is to assume that the debt government takes on, trillions and trillions of Republican debt, will made up for by the extra money people get from stocks. But here’s the kicker: if you assume the projection used to forecast social security troubles, stocks will end up doing too poorly to break even. Not to mention the fact that plan involves additional risk for each individual senior. (Sorry you invested in Enron! They looked solid!)

In normal times I would expect Republicans would show some balls like the Democrats did in 1982 and actually start raising Social Security investment or reduce benefits. I’d expect them to try to pay back the deficit like Clinton did so we could have some real option in making social security stronger. If they really believed their plan will work I would have expected Republicans (like Greenspan) to support Clinton’s proposal to move 15% of SS’s surplus into stocks. But we do not live in normal times. Sadly, we live in interesting ones.


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