My name is James K. Glassman. I am a columnist on financial, economic and political topics for the Washington Post. My column appears in many other newspapers throughout the country and the world, including the International Herald Tribune. I am also host of "TechnoPolitics," a weekly program on PBS TV that frequently addresses the interaction between finance and government. In addition, I am a monthly commentator on PBS's "Nightly Business Report" and a columnist for Intellectual Capital, an electronic magazine on the Internet.

With my collaborator Kevin Hassett, an economist at the American Enterprise Institute who was formerly a senior economist at the Federal Reserve Board, I am currently completing a book on the stock market, to be published in October by Times Books, a division of Random House. While I am not a trained economist, I have been writing about finance and public policy and the relationship between the two for nearly 30 years.

Since October 1996, I have been the DeWitt Wallace-Reader's Digest Fellow at the American Enterprise Institute, a research institution in Washington. Much of my work at AEI has focused on investment aspects of Social Security.

Thank you for allowing me to address the committee this morning.

Nearly One Trillion in Stocks

The quotation below the title of this testimony is a quotation from Alan Greenspan, chairman of the Federal Reserve Board. It underscores the serious nature of the Social Security proposal offered by President Clinton earlier this year. That proposal would profoundly change the relationship between the government and the private sector, the engine of prosperity and hope for all Americans.

In his budget message on Feb. 1, the president proposed investing what he termed a "small portion" of the federal budget surplus over the next 15 years "in the private sector, just as any private or state government pension would do, so that we can earn higher returns and keep Social Security sound for 55 years."

Specifically, according to a Feb. 12 memorandum to the chief actuary of the

Social Security Administration:

"The president's plan calls for transfers to be made from the General Fund of the Treasury of the United States to the Old-Age, Survivors, and Disability Insurance (OASDI) trust funds for each year 2000 through 2014. The amount of the transfer each year would be specified in law as a percentage of the OASDI effective taxable payroll. In each year 2000 through 2014, 21 percent of the transfer would be used to purchase stock and 79 percent would be used to purchase special interest-bearing obligations of the Treasury. All dividends would be reinvested in stock until the market value of all stock held by the OASDI trust funds reached 14.6 percent of total OASDI trust fund assets. Thereafter, the percentage of total trust fund assets that is held in stocks would be maintained at 14.6 percent."

While the president says that only a "small portion"—actually a little more than one-fifth—of each year's transfers to the trust fund will go to stocks, the sums are enormous. By 2014, according to the actuaries, the U.S. government will own $921 billion worth of shares of American corporations.

To put this figure in perspective: California's public employee pension plan, the largest in the nation, has assets of about $150 billion, and the pension plan sponsored by General Motors, the largest corporate plan in the country, had assets of about $100 billion. The largest single mutual fund—Vanguard Index 500—has assets of about $80 billion.

The Social Security actuaries calculate that, between 2001 and 2030, the government will own, on average, 3.7 percent of the total value of the shares on the stock market.

Defining Socialism

Ownership of stock by the government raises deep and troubling issues.

The first is a matter of political philosophy: At a time when much of the rest of the world has been turning ownership of state-owned enterprises over to the public, in the form of stock issues, the president's proposal moves the United States in the opposite direction.

I do not want to sound overly dramatic, but, by definition, the plan is a step toward the dictionary definition of socialism: government ownership of the means of production.

Thus, Congress must first answer this question: Should the federal government have an ownership stake in private corporations?

My own answer is no, but this is an issue of first principles that all Members must decide themselves.

Second, even if you accept that the government should own shares of private companies, should it own so much?

Most large firms that are traded on major exchanges have broadly diverse ownership—which is one of the strengths of the American corporate system. For instance, Merck & Co., the pharmaceutical house, has only two shareholders with a stake of more than 1 percent: Fidelity Management, the largest mutual fund house in the world, at 2.3 percent, according to Technimetrics, Inc., and Barclays Bank, a major manager of index funds, at 1.5 percent. Assuming that the federal government's ownership stake is spread across all corporations equally, it would hold 3.7 percent of the stock of Merck—or 50 percent more shares than the largest owner currently holds.

Let's look at some more examples. General Electric is America's largest industrial firm and the largest company on the New York Stock Exchange, with a market capitalization of $337 billion. Fidelity is its top owner, with a 4.0 percent share. Assuming the current stakes remain the same, the federal government would become the second-largest owner, at 3.7 percent, well ahead of Barclays at 2.9 percent and Bankers Trust at 1.7 percent.

It would also become the largest single owner of shares in Exxon Corp., the second-largest owner of J.P. Morgan & Co., the New York-based bank, and the largest institutional owner of Microsoft Corp. (but with a smaller stake than each of the company's three founders).

What does stock ownership mean?

In the American corporate system, stockholders are like voters in the political system. They elect representatives—in this case a board of directors—who in turn select managers to run the company. But the essential decision-making power in a corporation resides in the stockholders on a one-share, one-vote basis.

Is Insulation Possible?

The administration proposes to "insulate" the government from the direction of the companies whose stock it owns by setting up a neutral board. This board would evidently vote the stock.

But, as Chairman Greenspan has told Congress, "I don't know any way you can essentially insulate government decision-makers from having access to what will amount to very large investments in American private industry."

Certainly, the experience of state and local governments is not encouraging. A few years ago, the huge state employee pension plan in California, Calpers, brought its ownership weight to bear in pushing out the CEO of General Motors.

More often, political influence is expressed through specific rules and restrictions. For example, in the 1980s, 30 states prohibited the investment of government-employee pension funds in companies that did business in South Africa.

In a study of 50 state pension plans over the period 1985 to 1989, Roberta Romano of Yale University concluded that "public pension funds are subject to political pressures to tailor their investments to local needs, such as increasing state employment, and to engage in other socially desirable investing." She added that investment dollars were directed not just toward "social investing" but toward companies with lobbying clout.

After all, when he was Labor Secretary, Robert Reich urged private pension funds to invest in "economically targeted investments."

Drawing on a reference work by James Packard Love, the Cato Institute's Michael Tanner recently concluded that "23 percent of [state and local government-employee] pension systems have prohibitions against investment in specific types of companies, including restrictions on investment in companies that fail to meet the 'MacBride Principles' for doing business in Libya and other Arab countries; companies that are accused of pollution, unfair labor practices, or failing to meet equal opportunity guidelines; the alcohol, tobacco, and defense industries; and even companies that market infant formula to Third World countries."

Also according to the Love book, "approximately 42 percent of state, county, and municipal pension systems have restrictions targeting some portion of investment to projects designed to stimulate the local economy or create jobs."

One result of the politicization of pension investing in the states is that, as Olivia Mitchell of the University of Pennsylvania found in a study of 200 state and local pension plans during the period 1968 and 1986, "public pension plans earn[ed] rates of return substantially below those of other pooled funds and often below leading market indexes."

No wonder Greenspan told the Senate Banking Committee last July: "I know there are those who believe [government investments] can be insulated from the political process. They go a long way to try to do that. I have been around long enough to realize that that is just not credible and not possible."

Owning Microsoft, Philip Morris

Just use common sense. Imagine what might be called a "passive" system of investing tax dollars only in the companies that comprise the popular Standard & Poor's 500-Stock Index, which roughly includes the 500 largest stocks listed on U.S. exchanges, weighted according to their market capitalizations–or the number of shares they have outstanding times the price per share.

The largest stock in the S&P is Microsoft, which is currently being prosecuted by the Justice Department for alleged anti-trust violations. Should the government be the largest institutional shareholder in a company that the government is suing? That would be quite a conflict of interest. Government shareholders might want to vote to settle the lawsuit, or agree to break up the company—even if such a step were not in Microsoft's interest.

Microsoft represents 3.5 percent of the value of the S&P. So, assuming that ratio holds, by 2014, of the government's $921 billion in estimated stockholdings, a total of $32 billion—or nearly $300 per American family—will be invested in Microsoft.

Or consider the number-two stock on the S&P index: General Electric, which owns, among other things, the National Broadcasting Co. Should the federal government be the second-largest shareholder in a huge media company? Under the same S&P formula, Washington would own $29 billion of GE stock in 2014.

Perhaps the trustees on the government investment board could duck the Microsoft and GE problems, but what about a company such as Philip Morris Cos., Inc., which represents about 1 percent of the S&P (a $9 billion investment by 2014). Philip Morris, of course, is America's top purveyor of cigarettes. Should the hard-earned money of taxpayers support a firm that makes what many politicians believe to be death-dealing products.

My guess is that someone will quickly introduce a bill in Congress to forbid investment in companies that sell tobacco products. That will be followed by bills that restrict investing in firms that sell alcohol or run casinos or that operate plants that exploit cheap foreign labor and on and on.

But imagine if, by some miracle, politicians did not restrict ownership, and the federal government ended up with a large stake in Philip Morris. Then, whenever the notion of taxing cigarettes or increasing regulations would arise in Congress, the specter of a conflict would be raised. The legislation might make sense socially, but it would reduce the company's profits and thus hurt America's retirees.

Bias in Choosing an Index

Of course, no investment policy is truly passive. You can put money into an index fund, but you have to choose an index.

To choose the S&P 500 is to give excessive weight to large companies. Currently, there is no firm on the index with a market capitalization below $400 million, only 40 firms on the index that are listed on the NASDAQ exchange and only two that are listed on the American exchange. The S&P 500 includes only one biotech firm and only 13 computer hardware and software companies. It is hardly representative of the U.S. economy as a whole.

Does it really make sense for the earnings of all working Americans to be invested in fewer than 10 percent of all listed public companies and far less than 1 percent of all U.S. firms?

It would be impossible for any investing policy to prevent discrimination against particular regions of the country. Rep. Christopher Cox has pointed out that an S&P investing strategy "would expressively disadvantage Orange County [Calif.]. Our region is teeming with high-tech start-ups and small-to-medium-sized firms, but is home to only seven Fortune 500 corporations."

There are other indices. The payroll dollars could be invested in the Wilshire 5000 index, comprising every listed stock on the three major exchanges—7,200 of them. Wilshire investing, however, is technically difficult since such small amounts would go into some stocks. Vanguard, the mutual fund house with the largest public Wilshire fund, called Total Stock Market Index Fund, actually invests in only 3,118 stocks, using a computer model to take care of the rest. But should payroll dollars be entrusted to such a model?

Also, the Wilshire, like the S&P 500, is market-cap-weighted, which means that large companies get most of the money. Is that fair to America's smaller firms—and does it make sense as an investment strategy?

And why invest in listed companies at all? Few of them are run by members of minority groups or by women. And these are precisely the companies that don't need the extra capital that the government would provide.

Even if you could launch a successful index investing strategy, it would hardly be passive since each year, as my colleague, Carolyn Weaver of the American Enterprise Institute, points out, "billions of dollars would be pouring into companies without regard to who is polluting what, who is selling what damaging products to children, who has been convicted of violations of the law or is being sued by the federal government, who is operating in a country with offensive human rights policies or dangerous nuclear weapons policies, or...who is in dispute with which union, or who is moving jobs abroad or selling products made with child labor."

Advocates of government investing try to argue that it is no big deal. As President Clinton said, the federal government would simply be doing what a "private or state government pension would do." That is disingenuous. No state runs a pension system for all of its citizens. Instead, states make provision for the retirement of their employees, who voluntarily agree to accept employment from the state. Social Security, on the other hand, is universal and mandatory. It uses the tax dollars of every worker, whether he or she works for the federal government or not.

Not the Thrift Savings Plan

Advocates also point to the federal retirement plan, called the Thrift Saving Plan (TSP), as another example of benign government investing in stocks on behalf of employees.

But the TSP, which has only $50 billion in assets, is a defined-contribution plan, which means that employees direct where their retirement savings will go and that they actually own the accounts. When it established the TSP in 1986, Congress explicitly addressed concerns about political manipulation of funds by observing that it was the "inherent nature" of a defined-contribution plan that precluded tampering.

That inherent nature was private ownership. As House and Senate conferees stated in H.R. Conference Report No. 99-606 (1986): "Unlike a defined benefit plan... a thrift plan is an employee savings plan. In other words, employees own the money. The money, in essence, is held in trust for the employee and managed and invested in the employee's behalf until the employee is eligible to receive it. This arrangement confers upon the employee property and other legal rights to the contributions and earnings. Whether the money is invested in government or private securities is immaterial with respect to employee ownership. The employee owns it, and it cannot be tampered with by an entity including Congress."

Contrast this arrangement with the administration's plan. Payroll tax dollars that go into the Social Security Trust Fund, a general pool of money, controlled by government trustees, would be invested in the stock market—for the general welfare of the fund not for the particular welfare of an individual owner.

This is truly government money, as opposed to the money of an individual with the government acting as a fiduciary.

In fact, it makes me wonder: If stock-market investing by the government is so lucrative, why not have the Treasury issue more bonds at 5 percent and invest the proceeds in the stock market at 11 percent? The answer is obvious: Private investing is not a government function.

By pointing to the TSP, advocates of government investing remind us of an excellent model for a system of private accounts that could replace the current Social Security system. Under the TSP, federal employees have three choices: a stock mutual fund, run by a Barlcay's and based on the S&P 500 and two bond funds. These choices are too limited, but they are a start.

I would be happy to see Americans divert payroll tax dollars into TSP-style accounts that they would own themselves.

The Risks of Stocks Can’t Be Changed

But what about the risk of the stock market?

This used to be a major argument against Social Security reform that uses private accounts. For those familiar with extensive scholarly research on the stock market, it was never a realistic objection.

The nature of Social Security investing is that it is long-term. But the stock market has never suffered a decline, even after inflation, over any period of 17 years or longer. Bonds have. The standard deviation—a measure of volatility or risk —for stocks is lower than for bonds or even Treasury bills—over periods of 30 years or longer.

But the argument that stocks are risky hardly seems a viable argument now that President Clinton wants to invest tax dollars in the market.

Still, it is said that government investing in the stock market is somehow less risky than individual investing. In truth, the risk that exists in the stock market exists for all investors—individual as well as government.

It is true that government, through the taxing power, has the resources to provide a backup, or safety net, to individuals. But that would be true even if individuals themselves did the stock-market investing.

And, of course, the backup would be provided not by "the government" but by taxpayers who supply the government with their tax dollars. So, if a market disaster occurred, it would be individual Americans who would foot the bill, either way.

Is government a better investor than individuals? It's possible, but I wouldn't bet on it. Research shows that state and local government-employee pension funds certainly lag the market as a whole. Whose index fund investment would perform better? An individual's? Or the government's? Obviously, their performance would be the same.

My own guess is that, with rare exceptions, individuals would do better—for themselves and their families. They know their own risk tolerance and their own needs. They would likely be more careful, not less—since so much more is at stake.

Think of it this way: Who would do a better job buying your house for you? You yourself or a government agency? Retirement-funding decisions are not much different.

Inevitable Political Pressure

But, in the end, the main threat from government investing in the stock market is the inevitable political pressure that will be brought to bear. For that reason, Professor Romano, after her extensive study, recommended transferring control of state-employee pension assets from public boards to individual employees in order to reduce, if not eliminate, "the opportunity to apply damaging political pressure on decisions concerning those assets."

Alan Greenspan goes farther. He worries that a system of government investing would "have far-reaching potential dangers for a free American economy and a free American society."

For the government to use tax dollars to buy shares of private American corporations is for this country to take a giant step in precisely the wrong direction. It is also unnecessary. If higher returns on retirement contributions are needed—and they are—individuals are fully capable of seeking them in a system that replaces part or all of Social Security with private investment accounts that Americans would own themselves.

Thank you, Mr. Chairman and members of the committee.

James K. Glassman is a resident fellow at AEI.