Professor Franco Modigliani, Institute Professor Emeritus at the MIT Sloan School of Management and recipient of the Nobel prize in economics in 1985, pioneered the concept of the "wealth effect" in a study he did over 40 years ago. His research showed that for every dollar of wealth created by the stock market, individual consumption increased by a mere eight cents.
Modigliani, author of Adventures of an Economist (Texere, 2001) is a market economist, and he'd like to see the market's wealth-creating capacity applied to funding Social Security. But he's leery of giving individuals all the responsibility for managing their own contributions. He favors a dual approach -- with the government guaranteeing a 5% return on privately invested money no matter what (see BW Online, 10/11/01, "A Way Out of the Social Security Squeeze"). He recently discussed his views about Social Security and the September 11 terrorist attacks with BusinessWeek Online's Margaret Popper. Here are edited excerpts from their conversation:
Q: What will be impact on the economy of the events of September 11?
A: I think one has to understand that September 11 is a tragedy, a human tragedy -- and somewhat of an economic tragedy, but of a short duration. It's not going to change the course of history in terms of the economic development of this country by any means.
Q: Why not?
A: Because if you look at the [economic] magnitudes involved, they are small. When compared to the [U.S.] gross national product of over $10 trillion, the damage done is a small thing. It will take a while to mend it. It's a disruption. It's like a wound that you get on your arm: It incapacitates you for a while, but it's not going to change your life five years from now.
So when you're looking forward, I think the situation has not changed much. I would expect that 10 years from now, the economy will look pretty good.
Q: Have the events of September 11 rearranged spending priorities in a way that will affect the budget?
A: It's clear that whatever budget surplus there might have been has disappeared, and we now have a small deficit. That is a transitory situation.
Q: You have proposed funding the Social Security shortfall we're going to face in 30 years with the budget surplus. If we have a budget deficit, where is the funding for Social Security going to come from?
A: Well, there are two possibilities. One is that most of that will come from the government by simply agreeing to rescind the Bush tax cut, which will be inappropriate no matter what. We need that money for many other things. One of the things we need it for is to fix Social Security for good.
Now, if you do want to cut taxes, then you have to finance those cuts by raising Social Security contributions. And that rise need not be large if it starts right now. If you've got 40 years to build up a reserve, then we can do it in very small steps. If we wait, we have to raise contributions or cut benefits severely. So I say we should start now.
Q: Your suggestion is that there be a common fund for Social Security that invests in the capital markets. When you look at the performance of the markets over the past year, doesn't that seem like a risky strategy?
A: In some sense, the market decline of these recent months is what makes it possible to move a lot of the [Social Security fund's] money into the market. I would have hesitated to recommend entering during a bubble. But now it's a good time, actually.
If you look at the return over say 10, 15 years, even going as far as today, when the market has gone down considerably, you find that the returns are [already] pretty high.
Q: What kind of a return would you expect this fund to yield, and how can you guarantee that return?
A: The government should take the role of the final insurer [for more on Modigliani's plan, see "A Way Out of the Social Security Squeeze"]. We would use what is called a swap. The government would swap the return from the market against a 5% inflation-proof return. Historically, that's a good deal for the government, because the return has been distinctly higher than 5%. But they would set this up in a way that there would be a band -- any excess would be accumulated into the reserve fund.
If the reserve fund was exhausted, we maintain the benefits and we change the contribution rate, if necessary, to track the actual returns. We expect that those changes in contribution will be pretty small. It doesn't take much to adjust for it.
An alternative would be to move back to the typical pension fund of the past, where essentially you continuously calculate your liabilities and your assets on the basis of an expected return. If the two do not jibe, then you change the contribution rate, but smoothly, over 30 years or so.
Q: Where should the contribution rate and the investment return be to get us to where we need to be within 40 years?
A: We have made calculations assuming that, in the long run, there is a 5% rate of return. If you do nothing except invest in this portfolio [at a 5% rate of return], you really still are short of money by the time you get to 2050. So we have to make it up by either government or contributions.
In terms of contributions, we have worked out that it takes approximately a little less than a [one percentage point] increase from 12.5%, to say 13.5%. When you have 40 years to accumulate, that much will give you enough so that when you get to the point where there are not enough young people [working to support the retirees], you've got the return of the capital to replace the [workers' contributions]. The whole idea is to accumulate the capital, replacing the shortage of people.
Q: What would you invest in to get the necessary returns?
A: It would be bonds and equities in the same proportion that they appear in the broader market. The fundamental device is indexation. That means you have a portfolio which imitates the market portfolio, just like the famous S&P 500 trust [but with bonds as well].
Q: You advocate a central trust run by an appointed board of financial advisers. Why not let individuals handle their own accounts?
A: I find it hard to understand how people are seriously considering individual accounts. Instead of safety in your retirement, you get a gamble.
You save and save, and all that money is put into a gamble. That's not the way you want Social Security to work. You create risk. You create inequalities. People who have contributed the same [amount] may end up with a large pension or with a small pension, depending on [how they manage] their portfolio. You add a risk that you don't have to add. Individual risk, when pooled, disappears.
It's in the individual and social interest that everybody has a minimum. Social because you don't want people to be poor, because you don't want to pay for them.
Q: How do you ensure that the government manages the fund well?
A: I want a board to supervise and to resist any attempt of the government to deviate or to impose a will in the composition of [the fund's portfolio]. You know who I want at the head of the board? Paul Volcker. When he retires, Alan Greenspan.