Monday, 2 March 2009

Applied Cambridge Capital Theory or Causing Public Debt to Surface and Making Everything Even Worse

Angels thought you might all like to refresh your thoughts with a recent email:

There are two main alternative approaches to the provision of pensions.

The first is unfunded, in that pensions are paid, at a level of pre-defined benefits, out of the current pension contributions made by current employees. It is also called a re-distributive, or PAYG-Pay As You Go system.

It is a kind of pyramid banking scheme: in a pyramid bank (or Ponzi scheme) interest is paid out of new deposits, just like pensions are paid out of current contributions. Except that the banking pyramid goes bust when deposits unavoidably stop growing at least as fast as interest payments; and before it happens Mr Ponzi runs away with the loot. Whereas the pension pyramid can be perfectly sustainable, since there are always new depositors (current employees making pension contributions) and there are gradual and orderly withdrawals (pensions paid only after reaching pensionable age, and gradually, month after month). The unfunded system is sustainable as long as the number of pensioners multiplied by their individual average pension is no greater than the number of current employees multiplied by their individual average pension contribution.

Suppose the two sides balance. All future pensions are currently unfunded, and formally there is a pension debt today equal to today's pensioners' pensions for the rest of their lives. But the day of reckoning never comes, that debt is buried and as long as the balance is kept it never surfaces or needs ever to surface. It is a kind of seigniorage (the income that the state receives from the monopoly of issuing money), as long as the unfunded system is universal. If the two sides are not in equilibrium and pensions amount to more than current contributions, it is that shortfall cumulated and discounted over the residual lifetime of today's pensioners that represents today's "true" component of public debt on account of pensions.

If current contributions are higher than current pensions you can set aside a reserve for a possible aging of the population, or pension rises. If the population ages and such reserve is not there or is exhausted, then pensions must be reduced, or contributions raised, or pensionable age distanced, or some combination of all three, until balance is restored. Or the imbalance can be and is financed by the state budget. Otherwise you get the kind of PAYG system in Russia in the 1990s: First You Pay and Then You Go, as they used to say.

The second kind of pension system is funded with defined contributions but with benefits depending on the yield earned on the accumulation of individual contributions over time. In this case there is no problem with aging, or with retiring age, since what you get depends on what you put in, and the success of the investment to which your contributions were put, by you or by a pension fund of your choice. Choice is reputed to be one of the advantages of the system. It is also good for the development of financial markets, which is regarded as a good thing in itself.

And a zero pension debt? Yes, until a time like 2008-9 when insurance companies and banks go bust and stock exchange values fall by over a half. Then funded schemes end up with vanishing yields and capital values, i.e. pensions literally vanish. Ultimately the government will have to look after the pensioners no longer covered by their "funded" schemes. The pension burden will fall on the public budget - inexorably and regardless of whether pensions are funded or unfunded.

And, should you want to switch from a PAYG to a funded system:

1 - you still have the problem of the vanishing pensions in a recession, and moreover:

2 - when you switch you make the buried, hidden pension debt behind the PAYG, (today's pensioners' pensions for the rest of their lives, which is otherwise buried and as long as the balance is kept, never surfaces or needs to) surface as a real claim on current government resources. Whereas, if the unfunded system were balanced, and it was wished to privatise it, there should be no shortage of takers without paying the purchasers the value of the otherwise buried pension debt.


keep PAYG but adjust pensions/contributions/retiring age so as to make the system - if not balanced - at least keeping the imbalance at levels that can be a reasonable burden on the state budget, or;

if you want to change from PAYG to a fully funded system, consider the unnecessary cost-surfacing into the public budget, and don't necessarily expect the eternal boom needed to validate its alleged superiority.

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