Trusting Uncle Sam

Arnold Kling has a cute response to my blog entry on the Social Security trust fund:

A trust fund = an obligation to borrow? If your uncle Louie told you he was setting up a trust fund for you, and its assets consisted of his obligation to borrow the money, how secure would you feel?

Of course, it’s not Uncle Louie, it’s Uncle Sam. And so I’d ask Arnold Kling which he would prefer of these two options:

  1. A trust fund of $10,000 placed in a 10-year FDIC-insured CD yielding 5%, which will be worth $16,289 at maturity.
  2. A US government promise to give me $16,289 in 10 years’ time, borrowing it if necessary.

Remember, here, that the reason that the $10,000 safe is that it’s insured by exactly the same government which is otherwise promising me the money. There’s not much to choose between these two options: some people might prefer the former, others the latter, but there’s not a huge difference.

Remember too that the assets of the Social Security trust fund are invested only in US government debt obligations: the fund is not allowed to take any kind of credit risk, let alone buy equity securities. So while you might like to take that $10,000 and invest it in the market, that option is off the table.

Kling continues:

You may feel confident that Uncle Sam will always be able to borrow. Don’t be so sure. A few months ago, one might have thought that Uncle Freddie and Aunt Fannie would always be able to borrow. That ended rather suddenly.

Actually, it didn’t. Fannie and Freddie never had any problems borrowing, they just had to pay slightly higher spreads than they were used to paying. Besides, the only reason that anybody had any confidence in Frannie’s ability to borrow was the fact that everybody knew their kind-hearted Uncle Sam would always bail them out in extremis.

And yes, Uncle Sam will always be able to borrow. That’s what "risk-free rate of return" means. Is it possible to conceive of scenarios where the US defaults? Yes — but under those scenarios it’s improbable, to say the least, that any real trust fund would be in much better shape than the recovery value on US debt.

So yes, in this case I’m happy with Uncle Sam’s promise. He might not be 100% reliable, but his promise is more certain than any investment in the market.

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