Month: August 2008

Without changes, the Social Security payroll tax will stop raising enough money to meet the system’s pension payment obligations in 2018, just 13 years from now. This funding shortfall can be corrected with only modest adjustments, if action is taken now. Indexing retirement benefits on the consumer price index rather than the average wage increases would eliminate most of the shortfall and modestly and gradually increasing the retirement age a few years would reduce the rest. Other adjustments are also being discussed. The change in the benefit index would reduce the planned increase in benefits and leave the real value of current benefits unchanged. Choose which ever way of saying it that sounds best to you. Both are correct.

The issue of privatizing or otherwise reforming the nature of the system is another matter all together. Evaluating such reforms calls for a clear understanding of the purposes we wish Social Security to achieve. Before we can intelligently debate whether SS should be a fully funded insurance program (whether with a defined benefit or a defined contribution) or continue as a pay-as-you-go entitlement, we need to debate the role we want it to play in our overall system of retirement income.

Traditionally most Americans’ retirement incomes come from employer based pensions and individual savings (home ownership, whole life insurance, and other investments). Schools taught the need for proper preparations. On August 14, 1935, when the country was still struggling to overcome the Great Depression, President Franklin D Roosevelt added a mandatory government pension when he signed the Social Security Act. In addition to old age pensions, the Act established unemployment compensation, and aid to children and to the ill.

Roosevelt intended for the old age pension provided by Social Security to be a mandatory, defined benefit pension financed by the contributions of the pensioner and his employers over his working life. The system provided a guaranteed minimum pension for those who worked and paid into it. However, the relationship between what a person paid in and ultimately received was never close. Those at or near retirement when the system started were allowed benefits that were financed by young workers who would not draw their own benefits for many years. Pay-as –you-go financing is the cause of the upcoming financing problem as baby boomers swell the ranks of the retired. “As a result, the ratio of workers paying Social Security taxes to people collecting benefits will fall from 3.3 to 1 today to 2.1 to 1 by 2031.”[1] It was over 8 in 1955. The tax burden on those currently working is raising fast.

In its current form, Social Security’s old age pension is a complicated structure that is neither a sound insurance or pension scheme nor a well-designed and targeted safety net. The payroll taxes that finance it “account for more than 25% of all federal revenue; its payments represent more than 20% of all federal spending. For almost two-thirds of American’s pensioners, Social Security payments make up over half their income.”[2] As a social safety net, it does not target benefits or redistribute income in a clear and defensible way. As a compulsory, government administered pension, it is not financially sound and is considered by many to be an inappropriate and unnecessary government intrusion into private life.

How the system should be reformed, if at all (rather than merely fixing its demographic based financing problems), depends on how as a nation we answer the following questions: “Is Social Security a planning vehicle that an individual uses for his or her own retirement, or is it a pooling of resources so that all of society can meet the needs of its older members? Is it about each person saving for himself, or is it a matter of young helping old and rich helping poor?”[3] Should Social Security be part of the social safety net that Ronald Reagan spoke of for a society in which individuals and families are basically responsible for their own lives, or should it be an instrument of collective social responsibility for public welfare? The attitudes behind different answers to these questions reflect the great divide that has always separated (in varying degrees) Republicans and Democrats. But there may be a proper place for each view.

World Bank research found “that financial security for the old—and economic growth—would be better served if governments develop three instruments, or ”pillars,” of old age security: a publicly managed pillar with mandatory participation and the primary goal of reducing poverty among the old; a privately managed, mandatory saving system; and voluntary savings. The first covers redistribution, the second and third cover savings, and all three coinsure against the many risks of old age. By separating the redistributive function from the saving function, the amount of spending in the public pillar—and the tax rate needed to support it—can be kept relatively small. Spreading the insurance function across all three pillars offers greater income security to the old than reliance on any single system.”[4]

“A central recommendation of the [World Bank] report is that countries should separate the saving function from the redistributive function and place them under different financing and managerial arrangements in two different mandatory pillars—one publicly managed and tax-financed, the other privately managed and fully funded—supplemented by a voluntary pillar for those who want more.

“The public pillar would have the limited object of alleviating old age poverty and coinsuring against a multitude of risks. Backed by the government’s power of taxation, this pillar has the unique ability to pay benefits to people growing old shortly after the plan is introduced, to redistribute income toward the poor, and to coinsure against long spells of low investment returns, recession, inflation, and private market failures.”[5]

For the United States, the World Bank’s advice suggests a much smaller public pillar (the existing Social Security system), targeted on the poor (means tested) whether they had worked and contributed to retirement income or not. It would be financed from the government’s general revenues, not from wages if there were any. This social safety net would be supplemented by the second, mandatory savings pillar, which should sharply limit the need to resort to the first pillar. This mandatory, defined contribution, second pillar would be satisfied by qualifying (and regulated as now) company pension funds, 401K plans, or social security tax contributions to private mutual funds. Reasonable, but not excessive, restrictions and safeguards would be required. Recent experiences with pensioner losses with defined benefit pensions when their employer goes bankrupt indicate that further reforms of the private pension system are still needed as well.

The system would insure that those who could, i.e. those with jobs, would save enough for minimally acceptable levels of retirement income, but would still protect those who had not adequately protected themselves, whether from inability, short sightedness, or bad luck. Allowing workers to manage more of their retirement savings has several advantages. More would be invested in stocks and private bonds, which historically have yielded more on average than government bonds. Such savings would be part of the pensioner’s estate and any unused part would be passed on to his/her heirs. Both the reduction in wage taxes and the real savings of private pensions would tend to increase the supply of labor and national savings and investment, and thus economic growth. Fully funded benefits from saving would be free of the demographic problems now besetting our pay as you go system. Benefits from the second tier would be closely related to contributions, which would tend to increase saving (and economic growth) and to be seen as fair. Workers would become capitalists and thus potentially more sensitive to the health of the economy. Those who could not contribute enough, or experience poor returns on their investments would be protected by the first, public pillar.

President George W. Bush’s current proposals for Social Security combine both financial fixes for the existing system and substantive reform of the system by introducing “personal accounts.” His recent proposals may be seen as transitional steps to the above system. However, like the existing system, current proposals constitute a mixed and rather incoherent collection of ideas. The final result will be more satisfactory to everyone if the details now being debated contribute to a coherent overall three pillar plan for the provision of retirement income and medical care.

---

[1] “Fast Facts and Figures About Social Security, 2004,” U.S. Social Security Administration. http://www.ssa.gov/policy/docs/chartbooks/fast_facts/2004/ff2004.html#financing

[2] “How to mend Social Security,” The Economist, February 12 2005 p 10.

[3] Steven Mufson, “FDR’s Deal, In Bush’s Terms,” The Washington Post, February 20, 2005, page B3

[4] “Averting the age old crisis for the old,” World Bank Policy Research Bulletin, August – October 2004, Volume 5, Number 4. http://www.worldbank.org/html/dec/Publications/Bulletins/PRBvol5no4.html

[5] Ibid.

The Washington Post has published an outstanding report on the Commanders Emergency Response Program (CERP) in Iraq with the provocative title "Money as a Weapon" [1] CERP is an effort to be smarter about ‘winning hearts and minds” in Iraq by behaving more like a private charity. It has good and bad aspects and illustrates the inherent disadvantages of government employees spending tax payers’ money compared to spending their own money or private enterprise (or charity) employees spending the owners’ (donors’) money.

Any economic activity by groups larger than a family faces the challenges of coordination and monitoring the performance of the individuals within the group. If you are a parent, you know that this challenge exists even within the family. These challenges exist for private sector enterprises operating in free markets as well as for government bureaucracies. On several occasions I have noted that governments suffer serious disadvantages in these regards, but as there are some things only governments can do we need to put up with them while limiting government as much as possible to what only it can do.

Private enterprises have the advantages that they are risking their own money and are thus able to take greater risks (both in how they address the coordination and monitoring challenges and in what goods or services they choose to provide), and that they are forced by competition to make good decisions or parish. They are disciplined by their bottom line (profitability). Governments, on the other hand, must be accountable to the public for the use of tax money. Thus they require more rigid and intrusive performance monitoring procedures (more reporting than doing). In addition to adding an extra layer of cost, this tends to under value and thus stifle creativity. Civil service employees, for example, tend to be rewarded by length of service rather than performance evaluations to ensure that bosses do not show favoritism to friends and relatives. Public school teachers in many states in the U.S. suffer from the performance stifling impact of seniority systems with tragic results for the quality of public education. Even efforts to introduce merit pay for government employees are fraught with risks because of the absence of a bottom line and competition.[2]

In addition to being a smarter approach to overcoming terrorists and insurgents in Iraq, CERP also attempts to overcome the sluggish bureaucracy inherent in government programs. “Soldiers walk the streets carrying thousands of dollars to pay Iraqis for doorways battered in American raids and limbs lost during firefights. Sheiks appeal to commanders to use larger pools of money locked away in Humvees and safes at military bases for new schools, health clinics, water treatment plants and generators, knowing that the military can bypass Iraqi and U.S. bureaucratic hurdles.”[3]

CERP “has so far spent at least $2.8 billion in U.S. funds.”[4] That will pay for a lot of battered doors. All of it was handed out in U.S. dollar bank notes by American soldiers. “The program is intended for short-term, small-scale ‘urgent humanitarian relief and reconstruction.’ But as the broader $50 billion effort to rebuild Iraq with big infrastructure projects runs dry, CERP is by default taking on more importance as a reconstruction program, something it may not be equipped to do in a coordinated, nationwide way.”[5]

It is obvious that solders walking the streets can make quick and beneficial judgments about where a few bucks will get the best result in ways that more bureaucratically controlled procedures could never dream of. Most of the solders I met in Baghdad were fine people and could be counted on to serve their country’s interests first. I seriously believe that very little of this cash found its way into our solders’ pockets (but reread Catch 22 or M*A*S*H for a different perspective). Thus the broken door and missing limbs payments and candy and t-shirts for the kids are surely some of the best money we are spending in Iraq. However, it suffers at the end of the day what all government programs suffer from: the solders are giving out taxpayers’ money and thus are not guided by a bottom line of their own. This particular innovative, responsive, and flexible program also suffers a lack of coordination with broader efforts to pacify and rebuild Iraq.

I have an additional problem with the way this program is implemented, which is modest but not trivial, which is that U.S. dollar bills are being used rather than Iraq’s own currency. Doing so undercuts the development of Iraq’s monetary system, makes the monetary policy of the Central Bank of Iraq more difficult, and pours hundreds of millions U.S. dollar bank notes into the country in ways the make anti money laundering and combating the financing of terrorism measures impossible. When Iraqis exchange these dollars for dinars, where do the dollars wind up? Iraqi dinars could and should be used for this operation.[6]

“CERP is, in fact, a reconstruction program in addition to being a counterinsurgency weapon.”[7] The real problem with the program comes with the larger expenditures—the “schools, health clinics, water treatment plants and generators, etc.” These are all good things potentially but schools with no teachers, health clinics with no medicine, are a waste of money. “A $33 million hotel, office and retail complex at Baghdad International Airport” may be the best use of that money, but it is very unlikely that the mechanisms for allocating CERP cash resulted in valuing this project against all others being financed by the U.S. or Iraqi governments. That is exactly what government budgeting is all about (or should be)—setting priorities. Resources (money) are limited and thus projects must be prioritized in order to finance the most valuable ones to get the highest value per tax payer dollar (or dinar). Furthermore, the value of one project, a farm irrigation system say, may depend on other projects, such as the roads needed to transport farm output to market. Thus an overview of all projects and coordination among them may also be important, which CERP does not provide but USAID does (or at least tries to).[8]

“Outside Kirkuk, in northern Iraq, an $8.3 million water treatment project completed in February with CERP funds took more than two years and was $1.7 million over budget — and it is not far from another water treatment system that USAID paid $4.1 million to build two years ago.” In another more successful example, “In the violence-prone city of Ramadi, Army Capt. Nathan Strickland and his battalion used CERP money to hire day laborers to clear away trash and rubble. The military strategy: Get young men to pick up shovels instead of guns.”[9] I remember in the early months of American occupation of Iraq Peter McPherson, assigned to the Coalition Provisional Authority to oversee the reconstruction of Iraq, killed a similar idea as wasteful welfare.[10]

Over a trillion dollars or more later we have learned a lot, made many adjustments, and things are going better in Iraq. The Post article is full of fascinating examples of successes and failures and the difficulties of making the government function more like the private sector. Of course, it raises the question that should always be raised of whether this was really something our government should be doing in the first place.

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[1] Dana Hedgpeth and Sarah Cohen, “Money as a Weapon”, The Washington Post, August 11, 2008, Page A01.

[2] “David Whitman, in his book "Sweating the Small Stuff: Inner-City Schools and the New Paternalism," reports that in Chicago from 2003 through 2006, just three of every 1,000 teachers received an "unsatisfactory" rating in annual evaluations; of 87 "failing schools" — with below-average and declining test scores — 67 had no teachers rated unsatisfactory; in all of Chicago, just nine teachers received more than one unsatisfactory rating, and none of them was dismissed.” Quoted by George F Will in "Where Paternalism Makes the Grade", The Washington Post, August 21, 2008, page A15.

[3] Ibid.

[4] Ibid.

[5] Ibid.

[6] A modest problem with doing so currently is that the largest ID bill (25,000 ID) has a dollar value of only about $20.00.

[7] Ibid.

[8] In the interest of full disclosure, I am BearingPoint’s Senior Monetary Policy Advisor to the Central Bank of Iraq under a consulting contract financed by USAID. I am expressing my own views here only.

[9] Ibid.

[10] Warren Coats and Kenneth Weisbrode, "The Strange Tale of Financial Reconstruction in Iraq" October 25, 2003.

What follows is blatant self interested commercialism. Here is what my latest book (kind of makes it sound like I have a lot of them) is about and how to get it.

F O R  I M M E D I A T E   R E L E A S E

Book Launch:

Warren Coats’ One Currency for Bosnia:

Creating the Central Bank of Bosnia and Herzegovina.

349 pages

$42.50

Jameson Books

August 3, 2007

Washington, DC – Bosnia and Herzegovina has arisen from war-torn ruins to relative national stability in just ten years – in compelling contrast to the chaos of nation-building efforts elsewhere in the world. The story of rebuilding the monetary and banking systems from these ashes and their contribution the country’s healing and rebirth is a story of national triumph and world hope.

An architect of this historic feat, Dr. Warren Coats of the International Monetary Fund, now offers a chronicle starting before the fighting had stopped — and concluding with reflections about the on-going challenges of establishing stable monetary systems in post conflict countries.

For those who know of Coats’ reputation, the especially good news is that Coats provides insights into human and practical aspects monetary systems, and he offers lessons for those who would undertake similar quests.

What people are saying about One Currency for Bosnia:

• Michael Lind, Author of The American Way of Strategy: “Now that the challenges of rebuilding failed states and shattered societies are central to U.S. foreign policy, his [Coats] lively and fascinating account of one effort at national reconstruction is as timely as it is informative.”
• Mario I. Blejer, Director of the Centre for Central Banking Studies at the Bank of England: “His book not only clarifies potentially obscure economic concepts for the laymen but also illuminates the important interconnections between the economic and political aspects of post conflict reconstruction.”

About the author: Warren Coats is currently an advisor to the central banks of Afghanistan, Iraq, and Kazakhstan and is a director of the Cayman Islands Monetary Authority. During his twenty-six years at the International Monetary Fund he has provided IMF technical assistance to central banks around the globe including in Croatia, Bangladesh, China, Egypt, Nigeria, Turkey, the West Bank and Gaza Strip. He lives in Bethesda, Maryland.

• Monetary stability is a necessary precondition to a healthy economy. The author demonstrates in plain language the means to achieving this goal.
• Bosnia remains in the world’s headlines as a flashpoint of ethnic and religious conflict, especially the suffering of its Muslim inhabitants.
• Beneath the political rhetoric of peace, democracy and nation-building are the hard realities of economics. Policy writers and academics will find this book an invaluable guide.
• For all academic library collections dealing with history, foreign policy, economics, banking, and the Balkans.
• The Berkeley, Chicago, New York, Boston, and Washington, DC top bookstores should have this on their history, foreign policy and economics shelves.
• Milton Friedman’s more than 2,000 economics PhDs, like Coats, are a formidable market for serious works of economics and are likely avid reviewers.

Title

One Currency for Bosnia

Subtitle

Creating the Central Bank of Bosnia and Herzegovina

Author

Warren Coats, Ph.D. of Bethesda, Maryland

Author Bio

Warren Coats received his undergraduate degree at U.C. Berkeley and his Ph.D. at the University of Chicago. Currently advisor to central banks in four countries, he has led technical assistance missions to more than twenty countries, including China, Israel, Egypt, Iraq and the Czech Republic. For 26 years he held various positions at the International Monetary Fund.

This is both a fascinating personal narrative of the often colorful warriors rebuilding a part of war-torn Yugoslavia, and a detailed inside look at how experts can stabilize a nation’s currency and banking system. Written by an American who has led International Monetary Fund advisory missions to the central banks of more than twenty countries, this book, crafted in layman’s language — but of immense value to specialists in monetary and foreign policy initiatives — is an account of the behind-the-headlines work American and other economists do to bring peace and prosperity to former failed states.
Coats was involved in the creation of the Central Bank of Bosnia from before the Dayton Peace Accords. His “currency board” rules for monetary policy, and the creation of the bank, have resulted in the most successful state institution in the country.
Marking the tenth anniversary of the bank, the technical world of economics comes alive as the book unfolds like a mystery novel full of colorful and determined people determined to escape the disaster of a bloody civil war.

Order from Amazon:

Bosnia book endorsements

 

Front cover:

 

“Warren Coats’ well told account of the establishment of a currency board in war torn Bosnia and Herzegovina is fascinating and insightful reading.”

 

Robert Mundell, Nobel Prize in Economics in 1999

 

Inside before the title page

 

Robert Mundell,    Nobel Prize in Economics in 1999, Professor of Economics, Columbia University ram15@columbia.edu

 

“Currency board systems have become more popular since the collapse of the Soviet Union and with good reason: they provide a good option for monetary policy formation in countries where a suitable anchor currency is available. Warren Coats’ well told account of the establishment of a currency board in war torn Bosnia and Herzegovina is fascinating and insightful reading. His mastery of detail and intimate knowledge of that unusual environment, both political and economic, challenge and deepen our understanding of monetary systems and policies.”

 

Richard Rahn, Director of Cayman Islands Monetary Authority, former Chief Economist of the U.S. Chamber of Commerce, and syndicated columnist and author. rwrahn@noveconfinancial.com

 

“If you were going to build a monetary system that would heal the wounds of a civil war devastated country and help lay the foundation for economic recovery and development, what would you do? Warren Coats provides the answer given for Bosnia and Herzegovina in his well told story of the establishment of the Central Bank of Bosnia and Herzegovina. Readers of his book will follow the detective like uncovering of the workings of the unique Yugoslav banking and payment system and the challenges faced and overcome in replacing it with a modern, market based system.”

 

Mario I. Blejer,  Former Governor of the Central Bank of Argentina (2001 to 02) and Senior Advisor in the IMF (1980 to 2001). Currently Director of the Centre for Central Banking Studies at the Bank of England.

 

“Warren Coats describes and analyzes the very complicated and extremely relevant process of the establishment of Bosnia’s present monetary system in clear, highly readable prose. His book not only clarifies potentially obscure economic concepts for the laymen but also illuminates the important interconnections between the economic and political aspects of post conflict reconstruction.”

 

Back dusk jacket:

 

Carl Bildt, Former High Representative of the UN in Bosnia, Former Prime Minister of Sweden, Current Foreign Minister of Sweden carl.bildt@foreign.ministry.se

 

“The democratization process in Bosnia was one of the most exciting periods of my life. And in the lives of all the courageous people who were involved.  The history deserves to be told over and over again. I told parts of it in my own book. Now, Dr Coats has taken the trouble to recall his own fascinating experience with the establishment of the Central Bank of Bosnia and Herzegovina. His account is an invaluable contribution to the never ending story of the Balkans.”

 

Serge Robert, First Governor of the Central Bank of Bosnia and Herzegovina (Oct 1996 to October 1997)  sergejrobert@noos.fr

 

“This excellent book written by Warren Coats about the creation of the new Central Bank of Bosnia and Herzegovina is well worth reading. The author meticulously relates various aspects of history, monetary policy and human behavior in a clear, lively, humorous and enthralling style. The book reports how, after a grueling war, some men – still impregnated with rancor and distrust – bridled their own resentment, working together to build a monetary institution vital to their common future. Warren, with a great IMF team, played a major role in encouraging mutual understanding and co-operation. Today, on the eve of its 10th anniversary, the Central Bank has proved to be a real success. Warren Coats’ book will be an appropriate gift to mark such an event.”

 

Michael Lind,  Whitehead Senior Fellow, The New America Foundation and Author of The American Way of Strategy (Oxford, 2006) and other history and policy books and articles.  Lind@newamerica.net

 

“The mission of Warren Coats in Bosnia was as much diplomatic as economic.  Now that the challenges of rebuilding failed states and shattered societies are central to U.S. foreign policy, his lively and fascinating account of one effort at national reconstruction is as timely as it is informative.”

 

Steve Hanke, Professor of Applied Economics at Johns Hopkins U Baltimore MD and leading authority on currency boards.  hanke@jhu.edu

 

“The newly independent Bosnia and Herzegovina emerged in shambles from a bloody civil war in late 1995.  Warren Coats, a premier emerging market monetary expert, was central to the design and implementation of the currency board system that restored Bosnia and Herzegovina’s economy.  His book represents a scholarly and comprehensive, yet readable, realistic, and insightful account of one of the world’s most successful modern currency reforms.  One Currency for Bosnia should be required reading for all those who are serious about stable money.”