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February 24, 2005
Link to article: Guest Viewpoint: Social Security is about Insurance, not Savings
Guest Viewpoint: Social Security is about insurance, not savings
By Mark Thoma
When the Great Depression hit the United States in October 1929, the economic and social turmoil that followed exposed the typical family's need for economic security.
Workers who diligently endured the daily grind to support their families could find themselves suddenly thrown into unemployment simply because a new machine was invented, people changed their buying habits, production was relocated or the economy entered a recession.
Prior to industrialization, the need for economic security was not as great. In an agrarian economy, economic security is provided by extended family relationships coupled with the largely self-sufficient nature of farms.
Industrialization led to large economic gains, but the resulting migration to cities, the breakup of extended families, reliance on wage income as the primary means of support and an increase in life expectancy substantially increased the economic risk faced by the typical family. For a worker dependent solely on wages, the loss of a job means a total lack of income, not just hard times.
Without the help of others, abundant savings or some type of social insurance program, starvation is a real possibility. Even a worker who has assiduously saved for retirement can suddenly become impoverished due to such events as an illness or by living longer than expected.
Programs such as unemployment compensation and Social Security arose out of the Great Depression as a means to mitigate economic risk using the least amount of society's valuable resources.
Social Security was never intended to be an individual savings account. It was intended to provide a social safety net for people in retirement and families that lose a primary wage earner, and to provide the insurance at less expense than could be done privately.
People saving for their own retirement must save enough to sustain themselves should they live a long time or incur large health care costs. But this is not the optimal arrangement. Precisely the same goal can be attained with a smaller amount of savings by each individual. If everyone pools their funds, then each person needs to contribute only enough to support the average life and health expectancy of the group.
It is no different than fire insurance. Without such insurance, people would need to save enough to replace their homes should a fire break out. All risk must be borne individually, and most people end up saving far more than needed compared to an insurance program providing identical benefits. Others are left without any protection at all. With fire insurance, each person pays a smaller amount into a fund, and those unlucky few who need the insurance collect. There is no expectation that the amount paid in and the amount collected will necessarily match. Social Security insurance is no different.
But why does the government need to provide such insurance? Couldn't the private sector offer it instead to those interested in participating?
Before 1935, there was no such private insurance system available, so that is one reason to suspect the private sector will not offer such insurance. The lack of adequate pension plans offered by employers today is another.
In addition, economic theory suggests this may be an instance of market failure - that is, a case in which the private market does not provide the optimal amount of a good or service, such as insurance. Government intervention is necessary to correct the market failure.
Even if insurance is provided by the private sector, when left to provide for themselves many people do not make good decisions on saving for their retirement years. Social Security was created to solve the problems that arose when such insurance was left to the private sector.
The privatization debate has not paid enough attention to the insurance aspect of Social Security. It is social insurance, not an individual savings program, and it is important to recognize why it is optimal for government to provide social insurance collectively rather than leaving it to individuals.
Leaving it to the private sector didn't work before 1935, and there are good reasons to believe it won't work now.
Whether Social Security actually needs fixing is another debate. If it is to be fixed, anything that threatens to undermine the social safety net - and privatization is a step that pushes in that direction - also threatens the social contract the government forged with its citizens to provide for their economic security.
Mark Thoma (email@example.com) is a macroeconomist and a member of the economics department at the University of Oregon.