Brink Lindsey

Against the Dead Hand

There are obvious differences between the for-profit and nonprofit sectors, but there are underlying similarities as well. Both spheres may be seen as discovery processes: complex phenomena driven by the search for and application of socially useful knowledge. The differences between them arise from the fact that, in the nonprofit sector, provision of goods is divorced, at least in part, from the ability or willingness to pay. Because of this divorce, private nonprofit enterprises can face serious free-riding problems in securing funding for their operations or otherwise achieving their goals. Consequently, under certain circumstances—namely, when the need for comprehensive provision of the public benefit outweighs the advantages of decentralized experimentation—government can assume a useful role in providing public benefits. Specifically, government coercion can be used to overcome free-riding problems.

But even when government does step in, it does not follow that a headlong rush toward centralization is warranted. If government's role in providing social benefits is to be constructive, it must be structured so as to maximize openness to new ideas and to offer clear feedback about the effectiveness of those ideas. In other words, even when government asserts itself to advance some public goal, it should seek, wherever possible, to harness competitive market processes in service of its objectives. Top-down, monopolistic approaches should be shunned.

In the area of the social safety net, government involvement can promote more comprehensive protection against various risks that threaten destitution: old age, disability, sickness, unemployment, and so forth. In particular, it can supplement private insurance markets with 'social insurance'—a pooling of risk in which all are required to participate. It can also subsidize consumption of certain vital goods and services—housing and health care, for example.

But under the sway of the Industrial Counterrevolution, the government's role in providing a social safety net went far beyond merely compelling or subsidizing participation in markets. Instead of supplementing markets in a manner consistent with liberal principles, governments often supplanted them altogether with top-down, bureaucratic regimes. Rather than subsidizing participation in private housing and health care markets through voucher schemes, governments established public housing authorities and national health services. Programs to help the unemployed failed to guard against creating perverse incentives, and so ended up subsidizing dependency rather than encouraging a return to gainful work. And with respect to social insurance against the hazards of old age, governments created enormous, monolithic systems that violated basic precepts of actuarial soundness. A full discussion of the dysfunctions of collectivist social policy is well beyond the scope of this book. Here I focus only on the largest and most fiscally explosive element of the modern welfare state: state-run pensions for retired workers. It is this particular brand of social insurance that is primarily responsible for the welfare state's mounting financial woes.

The founding father of collectivized social insurance, Bismarck, was brutally candid about the political benefits of centralization. As ambassador to Paris in 1861 he had seen how Napoleon III had used state pensions to buy support for the regime. 'I have lived in France long enough to know that the faithfulness of most of the French to their government...is largely connected with the fact that most of the French receive a state pension,' he recalled later. For Bismarck, then, the appeal of social insurance was that it bred dependency on, and consequently allegiance to, the state. 'Whoever has a pension for his old age,' he stated, 'is far more content and far easier to handle than one who has no such prospect.'

Social insurance was thus born of contemptuous disregard for liberal principles: What mattered was not the well-being of the workers but the well-being of the state. With that animating principle, social insurance necessarily assumed a collectivist character. In particular, it would clearly not do simply to compel workers to provide for their own retirement; funded pensions that actually belonged to the workers would not inspire the proper feelings of dependency and subservience. Far better was the 'pay as you go' system in which the government, acting as intermediary and benefactor, would transfer funds directly from current taxpayers to current retirees.

The pay-as-you-go system flies flagrantly in the face of market logic. Indeed, when such ventures are attempted in the private sector, they go by the name of pyramid or Ponzi schemes and constitute criminal fraud. The essence of a pyramid scheme is that investors' money is never put to productive use; instead, it is simply diverted to pay off earlier investors. As long as new victims can be found, everything seems to work fine; eventually, though, the promoters of the scheme run out of new investors, and the whole house of cards collapses.

Pay-as-you-go public pension systems operate in precisely the same way. As long as the contributions of active workers are sufficient to defray payments to current retirees, the system is fiscally healthy. Indeed, in the early decades of such programs, it appears that the market has been outfoxed. Consider economist Paul Samuelson's smug optimism back in 1967:

The beauty of social insurance is that it is actuarially unsound. Everyone who reaches retirement age is given benefit privileges that far exceed anything he has paid in....How is this possible? It stems from the fact that the national product is growing at compound interest...Always there are more youths than old folks in a growing population....A growing nation is the greatest Ponzi game ever contrived.

Sooner or later, though, such hubris must receive its grim comeuppance. Shifting demographics impose the ultimate constraint. As populations age, the number of retirees begins to grow faster than the number of new workers, the former become a progressively heavier burden on the latter, until at last the burden is unsustainable.

Meanwhile, the perverse incentive structure of collectivized social insurance works to accelerate the system's ultimate breakdown. 'The fundamental problem with pay-as-you-go systems,' according to Jose Pinera, the world's foremost advocate of privatizing public pension systems, 'is that they divorce effort from reward. Wherever that divorce occurs on a large scale over a long enough period of time, disaster is inevitable.' In particular, workers have strong incentives to minimize or evade their contributions to the system, while retirees have an obvious stake in campaigning for higher benefits. Such dynamics steadily worsen the relationship between revenues and obligations and thereby hasten the eventual day of reckoning.

Today, with a global pension crisis that affects rich, developing, and postcommunist nations alike, the reckoning is at hand. Around the world, the ratio of active workers to retirees is shrinking. Promised benefits have spiraled out of control, while either demographic changes or widespread evasion reduce the relative size of the contribution base. Consequently, the hopes for retirement security of hundreds of millions of workers are now in serious jeopardy.

The inevitable Ponzi endgame is now obvious in the rich countries of the industrialized world. In the United States, for example, average life expectancy at birth was only 61.7 years in 1935 when Social Security was established—in other words, lower than the original minimum retirement age. Today, U.S. life expectancy stands at 76.5 years, and it is expected to climb to around 80 over the next 20 years. For most other industrialized countries, current and projected life expectancies are even higher. Meanwhile, fertility has dropped sharply. With the single exception of Ireland, birthrates in all the advanced countries are now below the 'replacement rate' of 2.1 children per woman. In Japan, the fertility rate is only 1.68; in Austria, 1.45; in Italy, a mere 1.33. Continued declines infertility are expected.

The upshot of these demographic trends is a steady erosion in the funding base for social insurance benefits. In 1950, there were 16 workers in the United States for every retiree; today the ratio is only three to one, and in 20 years it will have fallen to two to one. Elsewhere the outlook is even bleaker: By 2020, worker-to-retiree ratios are expected to fall to 1.8 in France and Germany, and 1.4 in Italy and Japan.

Social insurance in the advanced countries is indeed caught in a pincer movement, but not the one that Greider imagined. It is caught in a squeeze between rising life expectancy on one flank and falling fertility on the other. In that tightening vise, what once seemed so clever is now a catastrophe in the making. 'When population growth slows down, so that we no longer have the comfortable Ponzi rate of growth or we even begin to register a decline in total numbers,' a chastened Paul Samuelson wrote in 1985, 'then the thorns along the primrose path reveal themselves with a vengeance.' Already today, public pension spending in the rich member countries of the OECD averages 24 percent of the total government budget, or 8 percent of GDP. To fund these enormous outlays, the tax burden imposed on current employees has reached punishing levels: In Italy, Germany, and Sweden, for example, the combination of employer and employee contributions and personal income taxes now averages around 50 percent of gross labor costs.