A Hamiltonian solution to Social Security's bankruptcy

Jack Kemp
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Posted: Jan 24, 2005 12:00 AM

In the face of an audacious stonewall by Democrats against President Bush's ownership society vision, personal retirement accounts in particular, there is growing pessimism among some conservatives. A few Republicans fear that aggressively pursuing the vision could endanger their congressional majorities.

Nonsense. Now is not the time to go all wobbly. Now is the time to forge ahead boldly as George Washington and Alexander Hamilton did in the early days of the republic, when pessimism called the future of our grand experiment into question.

In the aftermath of the American Revolution, the new federal government under the Articles of Confederation was up to its ears in debt and continuing to borrow even more money from France, England and Holland just to stay afloat. In addition, the new government owed enormous sums to creditors who had financed the Revolutionary War through the purchase of war bonds - so-called "Continentals."

The new federal government had no revenue source to repay its debt and - for all intents and purposes - was bankrupt. These gloomy financial prospects were reflected in the fact that outstanding Continentals and other forms of Continental-Congress debt were trading at 10 percent to 15 percent of par. No one expected the new federal government to pay off the holders of its predecessor's bonds. Were George Gallup around at the time, he surely would have discovered more people believed in UFOs than believed the new federal government would repay its debt.

When the new Constitution was adopted in 1789, it would have been an easy matter to repudiate the mountain of debt incurred under the Articles and earlier by the Continental Congress on the grounds that the debt was unsustainable and that the acts of those previous governments did not bind the new republic. The Founding Fathers, however, understood the political and moral obligation to honor America's earlier financial commitments, and thus Article 6 of the new Constitution bound the United States government to accept the debts incurred by its predecessors.

Consequently, in 1790, when Treasury Secretary Hamilton submitted his "Report on Credit" requested by President Washington, he did not talk about "empty promises" and lament that previous Congresses had "promised more than the nation could afford." He did not argue for the debt to be repudiated on the grounds that the government had no moral, political or legal obligation to redeem the promises of previous governments, nor did he offer bondholders a small fraction on the dollar under the assumption that they would be grateful to receive anything at all, given their low expectations.

To the contrary, Hamilton recommended paying off all outstanding federal debt at face value. Promises made, promises kept!

To re-fund the debt, Hamilton convinced Congress to issue brand-new long-term bonds backed by gold and the full faith and credit of the United States government. He used those newly issued bonds to buy up the old "worthless" Continentals and other outstanding pre-Revolution debt, including that of the states. He refinanced the debt without spending a dime in "transition costs," and paid for it with the proceeds of higher economic growth. In doing so, Hamilton resurrected the moribund U.S. economy, made the dollar as good as gold and gave the entire world confidence that when the U.S. government promised something, it made good on that promise. Debt was part of the solution, not the problem.

Today we face a similar situation with Social Security, which - for all intents and purposes - is insolvent. According the Social Security trustees, by 2042, Social Security's debt obligation to beneficiaries will exceed its claim on the U.S. Treasury. The solution to Social Security's insolvency is not to repudiate the debt incurred when the government misappropriated workers' payroll tax contributions by using them to pay current retirees' benefits rather than allowing workers to invest the money to pre-fund their own retirement. The solution is not to cut Social Security benefits from what is promised to what is "payable." And the solution is not to raise taxes or to increase the retirement age.

The solution is to refinance the federal government's debt obligation to workers and retirees. As a new report from the Institute for Policy Innovation by Lawrence Hunter points out, the most rational way to do that would be to allow workers to save half of the payroll tax contributions in personal retirement accounts through which they could invest in real assets. To the extent that creates a cash-flow shortage, Congress could have workers lend the federal government whatever funds are needed to pay all current Social Security benefits. In exchange for the loan, the federal government would deposit into the taxpayer's personal-retirement-accounts inflation-protected, interest-bearing long-term federal bonds backed by the full faith and credit of the United States with no restrictions on the right of the account holder to resell the bonds in secondary bond markets.

Refinancing the Social Security liability in this way would not cause a short-term shock to the bond market or create upward pressure on interest rates because the government would simply issue new bonds to refinance an old debt obligation as Hamilton did. Nor would this approach threaten financial markets over the long run since the future financial obligation represented by the Social Security liability is already reflected in the current price of federal bonds, and any new forays outside retirement accounts into financial markets would be relatively small compared to the size of the economy.

Since new federal bonds issued to personal retirement accounts would simply refinance an already existing liability, no net increase in federal indebtedness results. There are no "transition costs" involved. Refinancing the Social Security liability through new-issue federal bonds would not entail new debt; in fact, it would make it possible to pay off debt and leave Social Security financially sound in perpetuity. To paraphrase Hamilton, debt incurred to refinance Social Security would be to us a "national blessing" as we create a truly democratic, capitalistic shareholder society.