What Does The Fed Have To Do With Social Security? Plenty.

Most of the people who closely follow the Federal Reserve Board’s decisions on monetary policy are investors trying to get a jump on any moves that will affect financial markets. Very few of the people involved in the debate over the future of Social Security pay much attention to the Fed. That’s unfortunate because the connections are much more direct than is generally recognized.

The basic story of Social Security’s finances is that, while the program is entirely sound for the near future, the program is projected to face a shortfall in the decade of the thirties. Under current law, at that point it would be necessary to reduce benefits from their scheduled level, unless additional revenue can be raised.

Of course the answer from those on the right is to cut benefits, and the sooner the better. Progressives, along with most of the public, would like to see the current benefit level maintained and possibly increased. Most workers are approaching retirement with little other than Social Security to support them, which means that cuts from currently scheduled benefit levels will mean serious hardship for many.

The Fed figures in this picture both directly and indirectly. The Fed is not always able to provide as much of a boost to the economy as it might like. Following the Great Recession of 2008 the Fed wanted to promote growth and employment. It did so by lowering short-term interest rates to zero and initiating its quantitative-easing policy of buying long-term bonds.

These policies helped stimulate demand by making it easier for people to buy homes or refinance mortgages and for businesses to invest. But by themselves, they did not come close to restoring the economy to full employment.

Although the Fed cannot always boost the economy as much as it would like, there is little doubt that it can slow the economy. Higher interest rates would dampen the housing market and discourage other forms of consumption. They would also slow investment. By raising interest rates, the Fed can slow the rate of growth, thereby keeping people from getting jobs, and propping up the unemployment rate higher than it would otherwise be.

If fewer people are employed, fewer people are paying into the Social Security system. This trend, therefore, directly weakens its finances. (The system will pay out less in benefits, but this result will not be close to offsetting.) In addition, lower rates of unemployment strengthen workers’ bargaining position. At low rates of unemployment, workers at the middle and bottom of the wage distribution have the bargaining power to secure themselves a share of the gains from economic growth.

This affects Social Security directly, since one of the main reasons that the program is now projected to face a shortfall in the decades of the thirties is that so much wage income has been redistributed above the cap on the Social Security tax, which currently stands at $117,000. Back in 1983, the last time major changes to the system were instituted, only 10 percent of wage income was above the cap. Because of the massive upward redistribution of the last three decades, 18 percent of wage income is now above the cap.

If the Fed allowed the unemployment rate to fall back to the levels of the late 1990s (@4.0 percent to 5.0 percent) and stay there, the share of wage income going to workers earning above the cap would fall, increasing the revenue going to Social Security.

In addition to the direct Fed policy can affect Social Security’s finances, there is also an important indirect channel. Over the long-term it will likely be necessary to raise tax rates to maintain scheduled benefit levels. Any substantial increase in taxes would impose a hardship on low and moderate income workers in the current context of stagnant wages. However if wages were rising in step with productivity, workers would be able to pay a somewhat higher tax rate and still have higher after-tax wages.

According to the most recent projections from the Social Security trustees, average hourly compensation in thirty years will be more than 60 percent higher (after adjusting for inflation) than it is today. If the tax rate were increased by 1-2 percentage points in order to prevent cuts to scheduled benefits, workers would still pocket close to 60 percent more for each hour of work in 2044 than they do today, assuming the gains from growth are evenly shared.

Whether most workers share in the gains from economic growth, or we continue to see the massive upward redistribution of income of the last three decades, will depend largely on the policies of the Fed. If the Fed allows the unemployment rate to fall back to the levels we saw in the late 1990s, then workers could anticipate substantial wage gains in the decades ahead. Covering the cost of Social Security will pose little problem.

On the other hand, if those pushing for higher interest rates now get their way, then most workers will not see their wages rise by much. In that case, paying for Social Security through the current payroll tax can be a problem.

People who are concerned about the future of Social Security, then, should be paying a great deal of attention to what the Fed does. Raising interest rates will not only affect the economy today, but it will also affect Social Security tomorrow.

Originally posted at CEPR.NET.