Saturday, November 26, 2011

Great Expectations

If you want to understand how America has corrupted itself while amassing $15T in debt, with even more in still-unborrowed, unearned entitlement liabilities, consider this thought experiment.

It is 1925. WWI is behind us, and the Roaring '20s are in full swing. GDP growth is torrid, new products and innovations abound. Incomes are rising, as are standards of living. Electricity, telephones and the car have revolutionized American life.

Income tax must be paid in one lump sum, while medical expenses and retirement are self-funded. People are still self-reliant.

Ten years later, global economic conditions, bad, constrictive monetary policy and too-liberal borrowing to buy equities have resulted in a market crash and simultaneous global recession which becomes the Great Depression in the United States. FDR's response is to print money to fund various government giveaway programs, while pushing Congress to pass the act that creates the greatest social welfare mistake, Social Security, which will inexorably change peoples' savings behaviors and the social structure of families.

Over the next few decades, young and old alike begin to rely on government promises of defined, ever-increasing benefits, and spend more, instead of saving for old age. Three decades later, Medicare and Medicaid are similarly mistakenly designed on the same lines as the original error, Social Security. Dependence on government for near-total pension and medical care funding are complete.

Now the experiment.

Imagine an America that never created Social Security, Medicare or Medicaid. Imagine that, like in 1925, future decades saw an America without government promises of retirement income and medical expense funding.

Instead, Americans remained self-reliant on themselves or their employers for retirement and medical care funding.

Since, ultimately, Americans were going to pay for these expenses themselves in some way, whether privately-funded, through taxes, or government borrowing financed by taxes on later generations, the real question is: how would their interim spending and savings behaviors have been affected?

What did Americans do before the government-promised benefit schemes of the 1930s and 1960s? I believe they spent more prudently, saved more, and expected to work longer. So if we'd never had the badly-designed Social Security, Medicare and Medicaid programs, it's likely people would have continued to do the same- spend less and save more for their own retirement and medical needs.

See, whether government provides it, or individuals save for it, the money for post-work living expenses and medical care come from the same place- wages earned while people work.

You can call it taxes, government borrowing or you can call it forced individual savings, but, either way, money for people's old age living and health care can only come from wages they, and/or future generations, don't spend.

If government had begun to mandate savings for both needs, kept in individual accounts, the effect would have been the same as if everyone behaved prudently and saved enough of their incomes to fund those needs.

However, the major difference would have been that there would have been no looming unfunded government-suppled defined-benefit pension liability or medical care funding, including generational shifts in the liabilities for them, because no such benefits would have been promised. Instead, savings would have gone to accounts meant to fund individuals' old age and medical care.

Of course, one other major difference is how these schemes affect the financial behaviors of individuals. When told government is supplying benefits, people spend more. Even though the money for the 'guaranteed' benefits has to come from taxes now and borrowing which is repaid with taxes on future generations. And it's a safe bet that cycling money through taxes, Washington and and back again adds to the cost of the benefits which are being funded by taxes on individuals' wages anyway.

There's one more difference. When benefits, instead of contributions, are promised, then timing can become mismatched. And one generation can enjoy benefits which leave debts for the next generation to pay.

Which is where we are now. But reasonable people realize that the defined-benefit schemes of the 1930s and 1960s have over-promised and won't be affordable for another generation. So, in reality, one generation promised itself lush benefits and left the bill to following generations.

That's why defined contribution schemes are inherently more fair and moral. They leave the cost of old age and medical care with the generation incurring them.

I find it fascinating to consider how families in the 1920s considered funding for the retirement of the adults in, say, the 1960s. Or their medical care. Without government programs promising those benefits, or company-supplied medical insurance, didn't they just save more and spend less, budgeting those costs into their existing lifestyles?

Why couldn't the same behaviors return for Americans, once we abolish unsustainable group defined-benefit programs? The money comes from the same place.

The real difference, in the end, affecting behaviors, is the expectations set by either self-funding or government promises of defined benefits. And the past 80 years have demonstrated that inappropriately-raised expectations by government's unaffordable and unsustainable promises have raised expectations to unaffordable levels for our entire society.

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