April 18, 2005

Risk, Return, Confusion

Peter Gosselin and Edwin Chen have a fun article in the Los Angeles Times on Bamboozlepalooza:
President Bush came to Ohio on Friday to highlight a state retirement savings system that he said showed that Americans would be better off handling their own old-age investments through personal accounts than relying on traditional Social Security.

But that state's version of personal accounts has attracted few takers among the people eligible — Ohio's 750,000 public employees. And records show that the most widely chosen version of the state-offered accounts has racked up a five-year earning record of 1.86%, about the same return that the president says Social Security produces.
Hee hee, sucker. But on a somewhat related note, here's something I honestly don't get. Some privatization advocates have advanced the line of argument taht we should be able to shift our payroll taxes into equities because they would get a better return there than they do under Social Security. Well, this argument has always been a bit disingenuous—the point of the program is the insurance aspect, not the return—but it also strikes me as conceptually misguided to boot. That is, even if you ignore transition costs, clawbacks, wealth transfer from poor to rich, ignore all of that, there's no logical reason to think perfectly rational people would get better total returns on their money under privatization than they do now.

Consider every man, woman, and child in America. No, wait, leave the children out of this. Okay, so currently every working man and woman puts his or her savings in some combination of Social Security/the bank/the stock market/etc. These investments have total risk X and expected return Y. Now anyone who thinks Y is too low, and is willing to assume a risk greater than X can do so right this very instant. Just take, say, the money you've invested in T-Bills and put them in some riskier stock. Or sell of your risky stocks and buy even more riskier stocks. Or take money out of the bank and buy some junk bonds.

The point is that almost anyone in America right now, it seems to me, could easily rearrange their current investments to assume an even greater risk and thus hope for an even greater return than they currently expect. If they so chose. The only thing they can't invest somewhere else are their payroll taxes. Under privatization, people could do that. But if everyone is currently at their optimal level of risk X and return Y (as all perfectly rational people should be, otherwise one ought to take money out of the bank and buy junk bonds, etc.), if that's true, then reinvesting payroll taxes in a riskier place with higher return shouldn't make any difference. People will just shift other investments around until they're back at X and Y.

No? Perhaps economists have already dealt with this argument, though I haven't seen it anywhere. Certainly the argument doesn't seem entirely correct. Perhaps it's wrong on account of people not being perfectly rational. Or the fact that for some (low-income) people, all of their savings are "invested" in Social Security so it's not possible to readjust and shift around. Or some other mysterious reason.
-- Brad Plumer 6:45 PM || ||