ENTITLEMENT REFORM AND THE GLOBAL BUDGET CRISIS / THE WALL STREET JOURNAL OP EDITORIAL ( HIGHLY RECOMMENDED READING )

OPINION

JUNE 3, 2010.

Entitlement Reform and the Global Budget Crisis

Putting Social Security on a sustainable path isn't nearly enough. But it would do a lot to convince markets that Washington can be serious.

By BURTON G. MALKIEL

This time it started in Europe. Stock markets are turbulent throughout the world, and risk aversion is rising. The Chicago Board Options Exchange's VIX index, which measures the volatility of S&P 500 options and is widely seen as a gauge of market fear, normally measures between 10 and 20. But last month the VIX index spiked to over 40 and remains at elevated levels. European banks have become reluctant to lend to one another, and a feeling of malaise has spread throughout the world. Even China, suffering from too rapid rather than inadequate growth, has not been immune.

There are certainly enough worries around to keep investors on edge. The U.S. economy, while no longer sinking, is facing strong headwinds as it slowly recovers from a sharp recession. Consumer balance sheets are still overextended, inhibiting spending, and the banking system is still sufficiently overleveraged to constrain banks from lending freely. The hoped-for strong V-shaped recovery is highly unlikely.

Elsewhere, Greece has experienced a solvency crisis, and the bailout packages that have temporarily avoided a repudiation of its debt will require it to adopt stringent deflationary measures. Other countries in Europe find themselves in frighteningly similar fiscal situations. The strains are likely to dampen growth and even threaten the stability of the European Union. While the United States is in better shape, strong economic growth is unlikely on either side of the Atlantic.

Western governments have made entitlement promises that are increasingly difficult to keep. As populations age (and Europe is in far worse shape than the U.S. on that score as well), strains on federal budgets become increasingly grave. Ratios of debt to GDP have risen to levels where Greek-style solvency crises are likely to proliferate. And rising tax burdens can prove self-defeating by discouraging investment and limiting economic growth. The only viable solution is reform of entitlement programs. What frightens investors most is that political processes seem incapable of dealing with long-run budget deficits before an economic crisis forces action.

In the U.S., Social Security provides an apt example of an entitlement program that must be reformed. While it's not the biggest part of our long-run budgetary shortfall, it is the easiest to fix. Indeed, the system can be made solvent for at least the next 75 years by some combination of three elements:

• Retirement ages. Life expectancy has increased by almost a decade since Social Security was introduced in the 1930s. But we've made only the smallest changes in retirement ages. We could increase the current retirement age schedule by one month a year for the next 36 years—i.e., a total of three years by 2046. After that, retirement ages could be further adjusted with changes in life expectancy. Workers in their 50s might have to work one additional year. We know that those who work after their "normal" retirement age are generally healthier, happier and more mentally alert and engaged than those who don't. Those who are unable to work would be allowed to retire under current schedules. Surveys suggest that younger workers, skeptical that Social Security will be able to pay the present schedule of benefits, would welcome putting Social Security on a sustainable basis.

• Revise the indexing formula. Initial Social Security benefits are based on actual monthly earnings during the 35 years in which the person earned the most. These earnings are then indexed to account for changes in average wages since the year in which earnings were received. The indexing formula used to be based on increases in the consumer price index (CPI). During the Carter administration, the index was changed to average wages rather than prices. Changing the formula back to using CPI rather than average wage increases would make a substantial difference in the projected Social Security deficit over the next 75 years.

A proposal more favorable for low-wage earners is called "Progressive Price Indexing." Under this proposal, low earners would continue to receive benefits promised under "wage indexing," while high earners would have their initial benefits calculated under a formula that used "price indexing" instead. Social Security actuaries have estimated that Progressive Price Indexing could reduce the actuarial deficit by more than 70% of the 75-year shortfall.

• Changes in the amount of earning subject to Social Security tax. As of 2009, $106,800 of earnings was subject to Social Security tax. That number could be increased to $125,000 or even $150,000. While this woulda represent tax increase, it would leave the top marginal tax rate—crucial for preserving incentives—unchanged.

Obviously, the devil is in the details. But some reasonable combination of all three of these measures could close the 75-year Social Security deficit. Almost more important than the progress that would be made in bringing the long-run fiscal deficit under control would be the psychological message that our political process is actually capable of tackling entitlements. Markets everywhere would celebrate our return to fiscal sanity on at least one entitlement program.

Higher prices for stocks could lower the cost of equity capital and enhance the long-run growth outlook considerably. By contrast, failure to solve problems that are easy to fix without changing the basic structure of our social safety net is likely to guarantee that our recent unsatisfactory economic performance will continue.
Mr. Malkiel is a professor of economics at Princeton University and the author of "A Random Walk Down Wall Street," 9th ed. (W.W. Norton, 2007).

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved