Social Security Reform and Financial Markets

Social Security is in trouble. With declining population growth and rising life expectancy, the cost of Social Security benefits is rising relative to payroll tax revenues. As a result, the Social Security retirement fund is expected to run out around 2030.1 Recently, the 1994–1996 Advisory Council on Social Security (1997) proposed three different plans to address the problem. Interestingly, all three plans involve Social Security investments in the stock market. This paper examines the impact of Social Security reform on financial markets, commenting specifically on the Advisory Council’s proposals and more generally on the question of how to operate Social Security under uncertainty and under adverse demographic conditions. The effects of Social Security on financial markets have long been the subject of debate among economists. The debate has generally focused on issues of intergenerational redistribution, using deterministic or certaintyequivalent economic models and taking for granted that government debt and the Social Security trust funds involve essentially safe securities. The thrust of this literature is that Social Security reduces individual savings incentives, raises interest rates, and crowds out investment. The debate is about how much and under what conditions. The Advisory Council proposals about equity investments raise significant new questions about the workings of Social Security under uncertainty. These questions are fundamentally about the allocation of macroeconomic risks between generations, about intergenerational risk-