Fix Social Security, Ease the Credit Crisis

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Remember the looming Social Security crisis? If you don’t, you’re not alone. The credit crisis and economic downturn have monopolized public attention to such an extent that the Social Security crisis that was at the center of the policy debate during President George W. Bush’s second term now seems forgotten.

This is unfortunate, for not only has Social Security not been fixed, but reform, if done right by tapping into the power of the market, can help provide new capital, which American businesses now desperately need.

To see how this could be done, it’s worth looking at the experience of Chile. Government officials in many other countries have looked at Chile’s reform during the 1980s as a model. The United States should take a look, too.

Nothing threatens a public pension system as much as a diminishing ratio of workers to retirees. In Chile, by the time reform began, this problem was severe. As Hernán Büchi, an economic adviser to the Chilean government at the time, notes, in 1979 there were only two-and-a-half workers to support each pensioner. “This ratio, combined with other deficiencies in the system, inevitably meant that the vast majority of workers were retiring on very low pensions,” he writes in his memoir, La transformación económica de Chile (The Economic Transformation of Chile). Clearly, the old system needed to be replaced with one that was sustainable.

The Chilean pension reform required three preparatory steps. The first involved, in Büchi’s words, “introducing some rationality into the system,” which meant doing away with major administrative inefficiencies that had plagued the system.

The second phase of reform involved “gradually reducing the tax on work that was implicit in pension contributions.” This “tax” arose out of the fact that public pension benefits bore no relation to payments made into the system, since they were largely paid via general revenues. Benefits were an unsupportable liability that threatened the finances of the entire government. Another goal of this phase was to bring these financing mechanisms under control. To do so, Büchi notes, “the tax collection systems had to be improved and government spending cut.”

The third, and most crucial, phase constituted “a top-to-bottom structural overhaul of the pension system.” The first step in this phase was to separate different kinds of benefits—old age, disability, workman’s compensation, and others—to be administered separately according to the needs of each kind of benefit.

Having reformed the framework of the pension program, Chile then moved to tap into the power and dynamism of the market. “The new pension system, with freedom as its guiding principle, is founded on the individual responsibility of each worker, reflected in his own savings capacity and his own individual account, and in the private administration of the funds by properly regulated companies,” writes Büchi.

Individual ownership of retirement benefits has helped families accumulate wealth over generations. Now parents, even of limited means, can bequeath more assets to offspring than they ever before.

Contrary to critics, the Chilean pension system does not leave low income individuals or those unlucky enough to have made poor investments adrift. The system, Büchi notes, retains a state-supported “social safety net,” that guarantees “a minimum pension at least” to workers who have not accumulated sufficient savings and who meet certain contribution requirements.

The lessons from Chile’s reforms are relevant to Americans, now that President Obama seems willing to tackle Social Security reform.

Moreover, the Chilean reform has special value given the current need to unleash capital. Büchi points out that Chile’s reform “helped create a substantial private capital market.” Money previously cycled through government agencies became available for private investment, providing entrepreneurs with needed capital and pensioners with better returns.

As the Obama administration and Congress struggle to address America’s credit crisis, they should take the Chilean experience into consideration. As the billions thrown at the nation’s economic troubles have turned into trillions, the last thing we should do is to go further into debt. Instead, we should unleash the wealth and savings creating capacities of the world’s most formidable economic engine: the American workforce

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