Social Security -- Getting Some Perspective
January 27, 2005; Page A2

In a U.S. Social Security debate in which partisans cite facts selectively to justify their positions, newspaper columnists occasionally turn for perspective to veterans on the sidelines.

One is Edward "Ned" Gramlich, a U.S. Federal Reserve governor who chaired a Social Security advisory commission a decade ago. The former dean of the University of Michigan's School of Public Policy and a liberal Democrat, Mr. Gramlich argues that it's time to fix Social Security. He advocates private accounts -- as long as they're on top of Social Security, not created by diverting payroll taxes as President Bush proposes. Here's how he sees today's debate:

Q: Does Social Security need major repair?

A: I don't think the system is in crisis. But we can make much more desirable changes if they're made early. The problem with waiting until the car is about to go off the road is that our options are constricted. It's hard to make sensible benefit cuts if people have already retired or are close to retirement. It's easier to do if cuts are well-advertised. In the past, we have waited, the benefit system has expanded and we've raised the payroll tax. At some point, we can't do that.

Q: Are we at that point?

A: We could raise the payroll tax a bit without huge economic consequences. But at some point we do want to get off the treadmill where we set a benefit system that we can't quite afford and then raise taxes to pay for it. I am, by the way, all for making the payroll tax slightly less regressive by raising the maximum wage subject to the tax.

Q: Why insist on preserving the existing Social Security framework?

A: If we were to go to a system that was entirely individual accounts, we probably couldn't have large backstop benefits to protect people. Many advocates of individual accounts would have something like a floor benefit level to protect people and private accounts on top of that, but that floor can be pretty low. The system we have now does work well and is really not all that costly. The cost is going to grow a bit as the population ages, but not much. It's tried and true. I don't see why we can't retain it.

Q: Then why did you back individual accounts as an add-on to Social Security?

A: I'd like to protect the basic benefits, but we need more saving. We need it because people don't save enough for retirement. We need it to finance the benefit system we have. And need it for the nation's macroeconomics. One way to get new saving is to raise payroll taxes. I didn't think that was either politically feasible or necessary. Another way is to mandate that people save a bit on top of Social Security. This differs from a tax increase because they would ultimately get the money back, but the main motivation is to increase national saving. Increasing national saving implies reducing consumption. It's not a surprise that this is a hard sell.

Q: Why do you oppose diverting payroll taxes to private accounts?

A: With carve-out individual accounts, we erode social protections at a time when we also seem to be witnessing the collapse of the corporate defined-benefit pension system. If we go to a retirement system that is entirely individual accounts, we also lose opportunities for income redistribution.

Q: The age at which workers get full benefits is rising to 67. Why would you lift it?

A: People in my grandfather's generation who got to age 65 paid into Social Security for 40 years and got benefits for about 10. People in my grandson's would collect benefits for more than 20 years. As life expectancy increases, the disparity gets increasingly unfair across generations. An easy way to restore fairness and to make a huge impact on the actuarial deficit of Social Security is to have the retirement age go up in line with overall life expectancy -- in an automatic way so Congress wouldn't have wrenching decisions every few years.

Q: Some say that'd be unfair to those with physically demanding jobs.

A: That's a bad rap. The retirement age would rise very slowly, about a year every decade. The main impact would be felt by workers in their 20s and 30s today. The share of workers who work in physically demanding occupations is falling every year and is going to be very low by the time they retire. I would still permit people to retire early and get reduced benefits. They're probably going to get a benefit cut, whatever happens.

Q: How well does our political system deal with Social Security?

A: We do have to make cuts in benefits or increases in taxes. We can do much more sensible things if we act early. But it's hard to generate the requisite urgency when the system is projected to be paying full benefits for the next 40 years or so. I'm not an advocate of the president's general approach, but I have sympathy for arguments that the president's people are making about the wisdom of acting now.

Write to David Wessel at capital@wsj.com

Fed Officials Weigh the Effects
Of Slower Productivity Growth

Almost a decade after Federal Reserve Chairman Alan Greenspan identified higher productivity as the key to inflation-free economic expansion, Fed officials see productivity growth slowing down -- and are studying how that may affect inflation and how fast they should raise interest rates.

At the moment, officials believe the productivity slowdown isn't dramatic enough to push inflation above its recent, moderate trend. The Labor Department said yesterday that inflation, excluding food and energy, was 2.2% in the 12 months that ended in December. That pace was unchanged from November but up sharply from a low of 1.1% in January 2004. (Full report)

"Inflationary pressures remained largely in check in December and early January," concluded a roundup of business conditions in the Fed's 12 districts, released yesterday.

That suggests the Fed, for now, is likely to continue raising its short-term interest-rate target, currently 2.25%, by a quarter percentage point at each meeting. It meets next Feb. 1 and Feb. 2.

But Fed officials are scrutinizing a recent deceleration in productivity growth, largely because its acceleration in prior years has been such a powerful damper on inflation. Fed governor Ben Bernanke said yesterday that he thinks productivity is likely to grow between 2% and 2.5% in the long run but that if it unexpectedly falls below that in the next few years, and the economy doesn't weaken at the same time, that "would likely [result in] higher inflation," and call for steeper increases in rates. If productivity growth accelerates instead, the Fed could adopt a looser monetary policy, he told the Council on Foreign Relations in New York.

Productivity refers to how much output a worker produces in an hour and helps to determine Americans' standard of living. Productivity growth also determines the economy's "speed limit," that is, how fast it can grow without putting upward pressure on inflation.

The faster productivity grows, the less costly it is for a company to produce a unit of output and the less pressure it has to raise prices. Conversely, a slowdown in productivity growth makes additional production costlier, prompting firms to raise prices to maintain profit margins.

Productivity growth averaged 1.5% a year from 1973 to 1995. Then, in a development Mr. Greenspan early on attributed to companies' ability to tap into high technology, it steadily accelerated, averaging 2.6% a year from 1995 to 2000. That enabled the economy to grow and the unemployment rate to drop sharply without the Fed's having to raise interest rates drastically out of fear of inflation.

From 2001 to 2003, productivity growth accelerated even further, to 4.2%. That meant that even though wages and benefits were rising between 3% and 4% a year, labor costs, adjusted for rising output per worker, were actually declining. That spectacular productivity performance led to the "jobless recovery," because firms were able to meet rising sales without more workers.

More important to the Fed, productivity growth has served as a powerful buffer against inflation; indeed, by driving labor costs down, it contributed to the Fed's deflation worries in 2003. As long as productivity remained strong, the Fed worried less about higher commodity prices and numerous other factors that normally would unsettle it.

But in the past six months, that buffer has started to shrink. Productivity growth slowed sharply to an annual rate of about 2% in the second half of last year, near the bottom of the 2% to 3% annual rate that many at the Fed believe it should achieve over the long haul. Unit labor costs are now rising. This leaves the Fed much less margin for error on inflation.

What is behind the slowdown? Mr. Greenspan said last year that the corporate technology-spending spree of the 1990s created a "backlog of unexploited capabilities for enhancing productivity," and that companies turned to this backlog when the economy turned down in 2001, in search of ways to cuts costs and avoid adding workers. The productivity slowdown in recent months might mean that companies have used up much of that backlog and will have to invest more to boost future productivity.

There appears little sign the Fed, or Mr. Greenspan, have lost their long-term optimism on the productivity potential of new technology. A continuation of strong productivity growth would be good for higher profits and wages, and even alleviate Social Security's long-term funding shortfall. A survey of purchasing managers conducted at Mr. Greenspan's request has found, year after year, that most feel they have exploited only half the potential of new technology. "Estimates of structural productivity growth remain high, although there has been some moderation recently," Tim Geithner, president of the Federal Reserve Bank of New York, said yesterday in a speech to the Business Council of Fairfield County, Conn.

Others are less sure. In a speech last year, Fed Vice Chairman Roger Ferguson cited signs that the pace of innovation is slowing: The price of computing power is not falling as rapidly as it once did and fewer new personal-computer models are being introduced. Even if the long-run trend for productivity growth remains bright, Fed officials are watching to see whether temporary factors pull it below that long-term trend for the next year or so, creating inflation risks.

Write to Greg Ip at greg.ip@wsj.com