Management of the Social Security Trust Fund

[wfhummel@xxxxxxxxxxxx (William F. Hummel)]

This essay attempts to clarify some of the issues involved in the
debate over how to manage assets of the Social Security trust
fund.

When money flows from the public to the government, as when taxes
are collected or Treasury bonds sold, the banking system reserves
diminish.  Conversely when money flows from the government to the
public, as when the government spends, the banking system
reserves increase.  These flows must be kept in near balance in
order to stabilize the reserves of the banking system, and
thereby avoid a liquidity crunch on the one hand or inflationary
pressures on the other.  This simple fact is key to an
understanding of the monetary issues involved.

The direct management of banking system reserves is the
responsibility of the Federal Reserve.   But the Fed depends on
the Treasury to balance its inflows against outflows as well as
it can.  Thus management of the reserves is a cooperative
activity between the two.  The Treasury does the coarse tuning
and the Fed does the fine tuning.

Treasury outflows now amount to about $34 billion per week on
average.  The Fed's fine tuning is done as a part of its open
market operations aimed at holding the interbank lending rate,
i.e. the Fed funds rate, on target.  That involves variations in
repurchase agreements in the order of $2 billion week-to-week.

When FICA taxes are collected, the reserves of the banking system
would drop unless the Treasury or the Social Security trust fund
spends an equivalent amount back into the public's hands.  Most
of the FICA tax revenues do in fact flow right back to the public
as SS benefit payments.

In principle, the SS trust fund could deposit the excess in
commercial bank accounts, which would restore the banking system
reserves.  Its earnings in that case, however, would be sub par.
It could also spend the excess on securities of the private
sector such as corporate bonds or equities.  In that case the
trust fund assets would be subject to credit and market risks,
and SS benefits would be dependent on the fortunes of the private
sector.  There are several good reasons why these options are not
advisable, but are not elaborated here.

Under present law the SS trust fund must use its excess revenues
to buy bonds from the Treasury on which it earns interest at a
fair market rate.  These are non-negotiable bonds which it can
liquidate with the Treasury as required to support the
obligations of the trust fund, i.e. to pay benefits.  The
Treasury itself must spend the trust fund excess, i.e. the
borrowed funds, in order to balance the monetary flow with the
public.  If it did not, the shrinkage in banking system reserves
would soon create a liquidity crisis in the private sector.

There are those who believe spending of the borrowed funds is a
raid on the SS trust fund.  Of course it is nothing of the kind.
The Treasury remains obligated and fully able to redeem at par
all of the bonds held by the trust fund.  The Treasury would have
to cover its obligation out of ordinary income taxes and/or bond
sales which are its only other source of funds.  It is well to
remember that the moneys in the Treasury general fund all look
the same, regardless of the source.

In principle the Treasury could deposit the borrowed funds
directly into commercial bank accounts, thereby restoring the
banking system reserves.  That would "lock up" the funds by
making them unavailable for non-trust fund spending.  Since the
Treasury would no longer have the use of those funds, it would
have to cover the shortage with an increase in income taxes
and/or bonds sales, or the equivalent in reduced government
spending.  The same applies to the present system when it must
redeem the trust fund bonds.

The main difference between the "lock up" option and the present
system then is in the timing of increases in income taxes and/or
bond sales.  Assuming the unified budget is in balance but trust
fund income is still in excess, the lock up option would require
the increased revenue when it was put into effect.  In the
present system, the increase is not required until FICA taxes no
longer cover benefits, i.e. when the liquidation of trust fund
bonds begins.  Of course changes in the budget surplus/deficit
situation would affect the timing in either case.

SS trust fund assets are still building rapidly.  It will be many
years before total payouts exceed FICA tax collections.  That
means the need for additional revenues to redeem SS trust fund
bonds is still a long way off.  It also means there will be a
crunch on taxes and/or T-bond sales when it occurs.  One way to
ease that crunch is for the Treasury to adopt the lock up option
and start depositing all funds newly borrowed from the SS trust
fund into commercial bank accounts.  It could then draw down
those deposits as needed to reduce the future taxes and bond
sales that would be required.

Although the Fed can monetize or demonetize large amounts of
Treasury debt, it would be totally impractical for the Fed to
monetize sufficient debt to liquidate the T-bonds held by the SS
trust fund.

It is important to note that the lock up plan implies the need
for additional taxes and/or debt sales, or reduced spending, when
and if adopted.  It is not surprising that the politicos who have
proposed such a plan seem to have overlooked that point.  But it
is ironic that Congress, while debating how to "fix" Social
Security, is fighting over how much to _reduce_ taxes.

William F Hummel