Note that this argument is not really one about whether public trust funds should
be invested in equities. Rather, it is about whether social security funds should be shifted
into equities through any mechanism -- either through public trust funds or private
accounts. In other words, the issue is purely one of whether diversification per se is
beneficial. Interestingly, proponents of private accounts often hail the diversification
potential of such accounts as a substantial social benefit, yet simultaneously claim that
diversification undertaken through a public trust fund would yield no benefits. At least
from a strictly economic perspective, that dichotomy does not seem to make much sense.
To be sure, how to best accomplish diversification involves numerous issues, including
both administrative costs and political economy issues, that are addressed below (see
Myths #7 and #10). For now, we focus on the effects of diversification absent such
administrative cost or political economy concerns. For convenience, we therefore
examine diversification undertaken through a public trust fund.
Underlying our examination of this myth is a fundamental theory -- the public
sector analogue to the Modigliani-Miller theorem -- that provides conditions under which
public sector financial structure makes no difference. The conditions were developed in a
series of papers by Stiglitz. Given perfect capital markets and the ability of individuals
to reverse the actions of government financial policies, such policies have no real effects.
Given imperfections in the financial markets, however, Stiglitz also shows that
government financial policy -- including its approach to investing its trust funds -- could
have important real effects. More recently, economists have highlighted imperfections or
non-convexities such as learning costs, minimum investment thresholds, or other factors.
In the presence of such imperfections and assuming that pensioners assume some of the
accrual risk from the government's financial policies (which means that the pension
system is not a pure defined benefit plan), diversification can produce real welfare gains
and possibly macroeconomic effects. The key insight is that given the imperfections,
many individuals do not hold equities -- and government diversification can effectively
eliminate the non-convexities, producing a welfare gain.
For example, Diamond and Geanakoplos (1999) examine a model in which there
are two types of consumers: savers and non-savers. The non-savers participate in a social
security program, and the government therefore "invests" on their behalf. Transferring
some of the social security trust fund into equities -- in other words, diversification --
produces a welfare gain for these non-savers. "Our major finding is that trust fund
portfolio diversification into equities has substantial real effects, including the potential
for significant welfare improvements. Diversification raises the sum total of utility in the
economy if household utilities are weighted so that the marginal utility of a dollar today
is the same for every household. The potential welfare gains come from the presence of
workers who do not invest their savings on their own."
Similarly, Geanakoplos, Mitchell, and Zeldes (1999) argue that if a non-trivial
share of households lack access to capital markets, diversification (either through a trust
fund or individual accounts) could raise welfare for these households. They conclude
that $1 of equity may be worth $1.59 to such constrained households. The myth of
neutral diversification thus arises from the implicit assumption that all households are at
interior solutions in terms of their financial portfolios; the papers explore the
ramifications of having at least some households at corner solutions. In a somewhat
different approach that nonetheless reaches similar conclusions about the non-neutrality
of diversification, Abel (1999) finds that diversification could raise the growth rate of the
capital stock in a defined benefit system.