The Great Experiment

Debt won't hurt, Treasury Chief says...President Bush's plan to partially privatize Social Security probably won't raise interest rates or adversely impact financial markets, even if the program entails borrowing hundreds of billions of dollars to finance it, Treasury Secretary John W. Snow said yesterday.

I see four scenarios:

1. The Modigliani-Miller theorem holds and the new borrowing will be offset by the reduction in long-term Social Security liabilities.  The transition will run smoothly.

2. Financial markets will get successively more scared as the proposal progresses.  Congress will postpone action and the plan will die a natural death.  A subsequent President will address the shortfall with a combined tax boost/benefit cap.

3. Moderate Republicans from the Northeast will back out for fear of losing their seats.  Few if any Democrats will cross the line.  A subsequent President will address the shortfall with a combined tax boost/benefit cut.

4. Bush will line up an increasingly partisan Congress and push the reform through.  The U.S. will have a short-term financial crisis, as Paul Krugman has warned.

My prediction: #1 and #4 are unlikely, I put my money on #2 or #3.

My take: I don't know of any policy, in the history of the world or the United States, that has relied successfully on the realism of the Modigliani-Miller theorem.  The theorem did deserve two Nobel Prizes, but it does not describe the world we live in, not even the market for U.S. government securities.  Keep in mind, the theorem also implies that open market operations will not even influence the price level.

My questions: If we can borrow all that new money "scot-free," will we truly reduce future expenditures on social security benefits?  Or will those funds simply be diverted, either explicitly or implicitly, to finance the Medicare shortfall?  Which way would you, as a bondholder, bet?

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