Social Security Trust Fund and the Money Supply

Bruce Krasting wrote a nice article for Business Insider about a discussion on Social Security between Senator Ron Johnson and Paul Krugman. That triggered a few questions in me about the Social Security Trust Fund and the money supply. Is the Social Security Trust Fund already part of our money supply and how will the government monetize the financial obligation? Here is the explanation from the Wikipedia Social Security Trust Fund page. Obviously this is a completely different funding mechanism than most pension funds and is an almost polar opposite of the funding style used for the Post Office employees in which they are required to prefund the pension plan for the next 75 years!

It is instructive to note that the $2.5 trillion Social Security Trust Fund has value, not as a tangible economic asset, but because it is a claim on behalf of beneficiaries on the goods and services produced by the working population. This claim will be enforced by the United States Government although the precise monetary mechanism of enforcement is yet to be determined. In order to repay the Trust Fund, the United States government has three options, which may all be pursued to varying degrees.

(1) The government may issue debt by selling treasuries. Thus, $1 in debt to the Social Security Trust fund is replaced with $1 in debt to a different lender. This scenario would increase the tax burden on future generations if the interest rate is higher on the new debt. If the new debt is more expensive and government revenues do not increase sufficiently either through taxes of economic growth, the government would be forced to cut spending on other programs (such as Defense, Education, Research) or else default on all or part of the debt.

(2) The government may raise taxes. If taxes are raised across the board, ironically, by reducing take home pay for workers, the government could make it harder for the younger, working generations to invest and save for retirement. However, if taxes are raised only on those whose earlier tax cuts were partially offset by these excess FICA contributions, namely those taxpayers whose marginal rates were reduced from 74% to as little as 28% during the Reagan Administration, the younger, working generations will not lose any ability to save or invest.

(3) The government may monetize trust fund obligations by transferring the treasuries held by the Trust Fund onto the Federal Reserve balance sheet. In such a transaction, the bonds would become "assets" on the Fed’s balance sheet, and the Fed would create money "out of thin air" to purchase the bonds from the government. Under such a scenario, the bonds are converted into cash, which would then be used by the government to cover social security payments. This scenario would likely lead to increased inflation, as it would inflate the money supply without directly increasing the amount of goods and services produced by the economy as a whole.