Poland: Money to the People

By Krzysztof M. Ostaszewski

In the late 19th century, German Chancellor Otto von Bismarck was the first statesman to introduce a system of social insurance: a universal, mandatory scheme of insurance with statutory benefits funded from a payroll tax instituted specifically for the purpose of that system, and managed by a government authority. The United States introduced its system of social insurance, the Old Age Security system, further supplemented by Disability Income and Medicare, in the Social Security Act of 1935, as a part of the New Deal policies of President Franklin Delano Roosevelt.

But the United States was not the first country in the Western hemisphere to have a social security system. Nearly ten years before the United States, in 1924, Chile, a small country spread along the Southwest coast of South America, started its system of social insurance. Interestingly enough, the first country in the Western hemisphere to introduce such a universal system of government old-age protection, was the first one to bring a free market reform to it.

On May 1, 1981, Chile privatized its social insurance system, while retaining its main feature of universality. For those wondering if the choice of Labor Day was accidental let us promptly advise you that it was not: the Minister of Labor and Social Security responsible for the reform, Dr. José Piñera, a Harvard-educated Chilean economist, chose it intentionally to bring attention to the this new approach to addressing the needs of the working people, who now celebrate their holiday on May 1, in the new global and competitive economy.

Why privatization? What is privatization? Before we address these burning questions, let us recall a vital economic debate of the early twentieth century, which turned out to have vast, powerful, and often unknown implications. Early twentieth century was marked by great enthusiasm for the power of the government to scientifically address major societal issues. If only the government appointed experts to do the job, to form a committee studying issues, and provide recommendations or policy directions, then, people believed, societal ills such as wars, poverty, ignorance, hatred, etc. could be cured. The most powerful illustration of that belief was the Bolshevik Revolution in Russia in 1917, which promised to build a new society based on the principles of scientific marxism-leninism. A striking objection was then raised by an Austrian economist, Ludwig von Mises, born in the now Ukrainian city of Lviv, then known as Lemberg. He claimed that although scientific calculations are a good thing, government would not be able to perform them. To the astonishment of proponents of socialism, he claimed that in the absence of free markets, no real prices of resources would be available, and thus calculations would be always flawed, resulting in misallocation of resources and dramatic waste.

A noted Polish economist, Oskar Lange, objected, and claimed that he would create a comprehensive mathematical model of the entire national economy, and would produce prices of all resources from such a model. Let us only note that Lange worked very hard, very thoroughly on his model, and became increasingly disillusioned with it, arriving in his late years in life at a very large dose of skepticism about government's ability to calculate prices, and about socialism in general. On the other hand, interestingly enough, according to Professor Malcev, former economic adviser of President Gorbachev, there was a time in the Soviet Union when a single person in a certain ministry in Moscow was in charge of setting over twenty million prices for the entire Soviet Union. One must wonder if the applicants for that position had to prove their supernatural, genius-like abilities ...

Hundred years have passed and we are now in an entirely different world. As the noted economic historian Robert Heilbronner stated, "Mises was right." We now know that we need free markets to provide us with information about prices. Yet in one area, we remain surprizingly unconvinced -- the area of retirement provision. How does one determine the price of retirement? The answer is: in the prices of capital assets. Our earnings coming from our productive activities are either spent on consumption or savings. Savings are used to purchase items which will provide us with the ability to consume in the future -- capital assets, such as stocks, bonds, or any other rights to future cash flows. People who own capital assets are normally known as: capitalists. Yes indeed, all people must become capitalists, if they want to possess ability to consume without working. Yet there comes a time when we have to stop working, due to old age. Do we all then depend on generosity of others? It is not necessarily bad if one person does that, but if most people do that, this becomes a major social problem. The solution is to save and invest for yourself, become a capitalist. Most cultures and religions throughout history told us to save 10% of our incomes.

Indeed social security program came to life precisely for that purpose -- to make everyone save and invest within the government system, and to help those who had too little resources of their own, by providing redistribution from those with greater means. But funds within social insurance systems never arrive at capital markets: they are instead immediately distributed to current beneficiaries. Granted, no bank or insurance company keeps cash in its vaults, they instead loan the money to others, hoping to earn a good rate of return. The problem is that in the government system what you get in the future is decided by the government, not by returns in capital markets. The result is that social security is a system of setting interest rates by the government. Here we revisit the contention of Ludwig von Mises: no matter how hard government actuaries will try, no matter how expert they are, they will err in their calculation, because government cannot calculate prices, and after all interest rates are just prices of money.

In the United States, the Social Security system has provided benefits to all generations which have received such benefits, far in excess of the accumulated actuarial value of their contributions (we are not talking about just poor people here, we are talking about entire generations). At the same time, the propensity to consume among the elderly has increased dramatically, resulting in a stunningly low national savings rate (below 6%). The system was very generous, without even fully being aware of that.

A recent 1994 study of the World Bank, "Averting the Old Age Crisis", indicated that virtually all systems of social security around the world are in crisis. Chile is an exception. What Chile did was quite ingenious. While retaining government's role in the supervision of the system, and assurance of its solvency and stability, all funds were diverted to private, individual investment accounts. In other words, money does not flow to the government, the people invest it in their own special retirement accounts. They are required to invest at least 10% of income, and government supervises the companies doing the investing. But suitable investments are chosen by the people, and by investment companies chosen by them. Participants are free to switch investment companies. As a result, the recipients of people's money know that they must earn good rate of return on these funds. And they have. Real rates of return are in excess of 12% annually (after inflation) since 1981. The Chilean economy, which used to be one of those Latin American basket cases of the 1970s, is now the Latin American miracle, with the highest standard of living in Latin America, and real growth rate over 7% since the reform. The savings rate has increased to 28%, which one would expect in a Southeast Asian country, but not in Latin America. Indeed, Chile has become an example for the rest of the continent. Similar reforms have been introduced by Argentina, Colombia, Peru, and recently Mexico, Bolivia, and El Salvador. One may indeed wonder if the next zone of economic miracle will not be Latin America, in contrast to the current admiration for the achievements of Southeast Asia.

There is a lot to be learned from the Chilean reform. The most important lesson seems to be that of humility for the experts. Even though we actuaries are better at calculating than most of the people, let us not forget that the interest rates, contributions, and benefits assumptions used by us come from the information provided by the every day activities of non-expert people. It is their money that we get to invest.
It is a wise idea to give money to the people, not to the government, and let their common sense play a role in placing of the funds, so that we can be well informed about the real prices of resources, and not be like that genius person in Moscow who once calculated millions of prices.

(Associate Professor of Mathematics and Actuarial Program Director at the University of Louisville, Kentucky).