I'd like to propose a straightforward form of Social Security privatization that avoids the need for the federal government to get involved in the stock market. Call it “opting out”. Here's how it works: we give Ms. Smith, a worker, the right to opt out of paying $100 in social security payroll taxes provided she also opts out of (say) $103 in future Social Security benefits. She can now save her $100 privately. She will consider herself better off opting out if she thinks she can earn a return of better than $103 for each $100 saved. Voila, who could object?

Wait, the anti-privatizers object: if she no longer coughs up the payroll tax, Social Security has less cash flowing in. That cash flow pays current retirees. To make up the shortfall, the Social Security Administration would have to borrow.

Fine, I say. Let it borrow. Let the Treasury issue a $100 bond to replace Smith’s taxes. Suppose the Treasury’s borrowing rate is 3%. Then the funds needed to retire the bond plus interest in the future ($103) have already been provided for by the fact that Smith has opted out of $103 in future benefits. Already scheduled future tax payments, no longer needed to pay Smith $103 in benefits, will be available to retire the bond. No tax rate increases or benefit cuts to current retirees are needed.

I’ve chosen these numbers (and ignored multi-period compounding) for illustrative purposes, but the idea generalizes. If the Treasury’s borrowing rate is actually higher, say 4%, set Smith’s buy-out price higher (she has to give up $104 in future benefits to shed $100 in taxes today).

Here’s the key point: so long as we set the price of Smith’s opting-out at the Treasury borrowing rate, and Smith can earn a rate of return in the stock market higher than the Treasury rate, then Smith gains from opting out, and nobody loses. QED: There exists a Pareto-improving form of Social Security privatization. The only way to deny the result is is to deny that expected stock returns exceed the Treasury rate.

Paul Krugman today (registration required) claims that “privatization” plans “invariably [my emphasis] assume that investing in stocks will yield a high annual rate of return, 6.5 percent or 7 percent after inflation, for at least the next 75 years. Without that assumption, these schemes can’t deliver on their promises.” Krugman is wrong. The Treasury rate isn’t as high as 6.5 or 7 percent after inflation, and for the opting-out plan it’s only the Treasury rate that the stock market needs to beat.

If Paul Krugman doesn’t think that the stock market usually beats the Treasury rate over retirement-savings horizons (20 or more years), then I suppose he must have none of his own TIAA-CREF funds in the stock market. All of his retirement savings must be in Treasury bond funds. Somehow I doubt that. If it were so, he should hire a new investment advisor.

POSTSCRIPT: According to the US Treasury, the current real (after inflation) 20-year Treasury rate, based on "closing real bid yields on existing TIPS" [Treasury Inflation Protected Securities], is 1.94%.