In many political circles this year, a mantra has emerged:  we cannot afford the public sector pension plans and we cannot afford Social Security – we must cut the future benefits. For example, George Biggs of the conservative, right-wing think tank American Enterprise Institute argues that even though public sector workers receive lower pay than comparable private sector jobs, it’s “just not fair” for public sector workers to have secure, attractive pensions:

There is no reason public-sector employees should receive retirement benefits that are either larger or more secure than those received by private-sector workers.

But like most one-liner economics arguments, when we consider the macroeconomic effects, we have to conclude it’s not that simple! In fact, we (as a macro economy and society – all generations) might not be able to afford to cut future benefits, despite the growing portion of society that will be over age 65 and not working when baby boomers retire.

Here’s why.  Consumer spending is 70% of GDP.  Reductions in consumer spending rapidly translate into stagnant growth and/or recession resulting in lower employment and fewer jobs.  Even slowdowns in the growth of consumer spending have negative job consequences.  Consumer spending benefits us two ways:  the spending supports a higher lifestyle (both quantitatively and qualitatively) by the people doing the spending, but it also provides the income for the workers who produce the goods.  This is what in economics is called the circular flow.  Spending by seniors is today a significant part of the circular flow.  Now picture the future. We know that seniors and retirees will be a larger portion of the population for at least the next 30-some years as the baby boom generation moves from working age to retirement and eventually dying.  Retirees are a critical part of the consumer spending.  As boomers retire, they become an even larger portion of consumer spending, both because there’s more retirees and because typically it’s the middle-aged and seniors that have the money to spend.  McKinsey estimates how much of that consumer spending will be accounted for by the boomer retirees:  40%!  As reported by Diane Jean Schemo:

At every stage of their lives, Boomers, the generation born between 1946 and 1964, have exerted a singular force on the economy. Cradled in the relative prosperity of the post-war years, they graduated from college in higher numbers and earned higher incomes than both their parents and their children. Boomers saved less and spent much, much more. By their sheer numbers and appetites, what Boomers do — how much cash they have in their pockets, and whether they save it or spend it — matters. Consumer spending accounts for 70 percent of economic activity, according to government figures. By 2015, Boomers will account for 40 percent of that consumer spending, according to a 2007 report by McKinsey Associates.

At present, lawmakers, politicians, and fiscal worriers are claiming that the future (typically distant future) pension and social security liabilities (promised benefits) are too much.  Governments cannot afford them today with today’s assets, incomes, an deficits they claim.  Now there’s a serious flaw in logic there: cutting future benefits/liabilities will do nothing to cut a present-day budget deficit, but let’s ignore that for a moment.  So, they argue for cutting promised benefits (often argued for SS) and/or shifting all of the risk to the future retirees themselves instead of the employers or government.  Typically this is done by proposing to end defined-benefit pension plans for public employees (much like the private sector did 20 years ago) or by calling for privatization of Social Security.  But like most arguments from one-liner economists, the world doesn’t work that way.  The macroeconomy is more complex.  These people assume that there’s no connection between today’s economy and the future promised benefits other than the government having to record a liability on it’s books.  Wrong.

You see, people make plans and those plans are based on expectations of the future.  What people spend now is based on how confident they are of their future income. So let’s go back to our future scenario.  Let’s now assume these one-liner economists have been successful.  Defined-benefit pension plans for public sector employees are either eliminated or cut back.  Maybe even Social Security has been partially privatized or future benefits cut.  Our aging boomer cohort sees it’s future retirement income as lower and as more risky and uncertain.  That means they cut back today’s spending now to rationally protect themselves against this increased risk. As they cut back today’s spending, that reduces overall consumption spending now. That lowers employment and GDP now.  Lower GDP and lower employment now means even bigger government budget deficits now (this effect would swamp any projected future savings – see the 2009 Federal deficit that resulted from lower employment).

Now none of this analysis should be new or surprising.  It’s basic stuff macroeconomists learned 80 years ago in the Great Depression.  But unfortunately, good macroeconomic analysis doesn’t lend itself to one-line political slogans.

The bottom-line:  If public sector defined benefit pension plans and/or Social Security future benefits are cut or privatized, it will have a negative effect today on government budgets – deficits get worse.  It will also mean a much leaner lifestyle for baby boom retirees.  How much?  The model developed by/for Social Security and Urban Institute projects that simply converting existing public sector defined benefit plans to quasi-private defined contribution plans could easily reduce the average boomer’s retirement spending by as much as $4,000 per year.

In the state of Utah, they have already debated and decided to end public sector defined benefit pension plans.  Yet amazingly, they never considered the huge impact this would have on  the Utah economy now and in the near future (from Schemo article in Remapping Debate – emphasis is mine):

Cutting pensions in Utah

Utah, one of 18 states to revamp its pension system since 2005, held a lively, often contentious, debate before moving to end its current defined benefit system for new workers earlier this year. It replaced it with a two-tiered system allowing new hires to choose either a defined contribution or a defined benefit plan. For the latter, the new rules limit the state’s contribution to 10 percent of an employee’s salary, allow retirement after 35 years’ service instead of 30, and lower the maximum benefit to 52 percent of an employee’s salary.

And yet, John Nixon, the state budget director, said he does not recall the impact of the changes on consumer spending coming up much in the debates over pension remedies. Nixon had neither heard of or nor seen a February 2009 report by the National Institute on Retirement Security, which uses Census and other government data in 2006 to assess the impact of state and local pension plans on the larger economy.

The study, entitled “Pensionomics,” found that every $1 Utah taxpayers spent in public pension benefits spurred $6.36 in economic activity in the state. State and local governments in Utah provided 37,186 retired workers benefits averaging $1,471 a month. These payments, the report found, triggered $1 billion in economic output, concentrated most heavily in retail sales and health care.

Nixon said that lawmakers in Utah, alarmed by a $6.5 billion fall in the pension fund’s assets in 2008, focused on the long-term liability to the state of its obligations to retirees, not on the repercussions of possible benefit cuts to the state or local economies — a discussion that usually focuses on a shorter time frame of 12 to 24 months.

“As far as the impact on consumer spending, that’s a whole different dialogue,” Nixon said.