Arnold Kling  

Phelps on the Dollar

Carnival of the Capitalists... More on Medicaid...

Edmund Phelps, who I once said might have won the Noble Prize had he been Scandinavian, ventures a perspective on the dollar and the trade deficit.

This model revolves around the epochal event hanging over the present situation: the explosion over the next few decades of Medicare and Social Security outlays for the baby boom generation. The key point is simple: In any surprise-free scenario, or equilibrium path, the expectation of this future fiscal burden causes the U.S. current account to go into surplus -- a surge of exports and import cutbacks -- until the period when the baby boomers' are exercising their huge medical and pension claims, during which the current account jumps into deficit. The logic is that the nation will do outsized saving in the early years to make room for the huge bulge of Medicare and OASDI (Old Age Survivor and Disability Insurance) claims that lie ahead; and since the global capital market is not going to place anything like the whole of that extra saving in U.S. capital, a large part of it must go overseas -- in extra exports the income from which is invested abroad. The horde of overseas assets is gradually sold off as the boomers are exercising their claims. (Maybe those surpluses would run 1% to 2% of GDP.)

Correspondingly, the dollar will be far weaker in this scenario than that imagined by the optimists. It must weaken enough to shift the current account balance from today's deficit not just toward a sustainable deficit level but to the needed surplus...

At the present time households are badly under-predicting their future tax liabilities -- or, if the U.S. government is going to cut entitlements -- over-predicting their future benefits. Either way, they are spending too much, so the current account cannot get out of deficit. Once households are better informed their spending and the dollar will both drop. (Yet budget and tax policy has to follow through.)

Because of our entitlement system, each of us is under the illusion that we do not have to save in order to meet our needs in old age. In the aggregate, however, this low saving is unsustainable.

For Discussion. How does this hypothesis relate to the debate over the effects of Social Security privatization?

COMMENTS (9 to date)
Edge writes:

Japan offers an example of a demographic trending older, ahead of USA. One might postulate that a portion of Japan's excess savings has been in anticipation of supporting an aging population.

In the relationship to SS privatization, if we were using a model like Kotilkoff's where we would raise additional revenues to fund personal accounts, we'd have a visible hand explicitly working towards the goal of increasing savings to fund an older demographic.

As it stands, we've got several counter forces that seem to allow us to suspend reality. First, we've got a flow of underpriced foreign goods flowing in to the country. Second, foreign central banks are supporting that flow by purchasing short term treasury bonds - substituting for domestic savings. Third, this has supported net dis-savings by the federal
government. Fourth, the federal government has engaged in a policy of shifting the tax burden, with FICA tax surplusses used to offset dis-savings from general revenues. This policy was interrupted during the 1990s but has accelerated since 2001.

All of these trends have been mutually reinforcing, and provide an illusory sense of well-being.

Privatization with borrowing to finance the transition (perhaps $5 Trillion of borrowing over 30 years) wouldn't address the net savings side of this balance, but might break these mutually reinforcing trends - most likely playing out by some combination of a breakdown in the treasury bond market; a crisis in general revenues; or a savings panic among boomers and others who belatedly realize the free lunch never existed.

Kotiloff-style privatization, where we bring in additional tax revenues, should result in an increase of net savings, and would involve considerably less risk of an implosion along the three axes described above. By increasing savings, the imbalances above would be more directly addressed. We'd still face a tradeoff of savings .vs. consumption, with domestic demand falling, but the odds of that resolving with a "soft landing" rather than catastrophically would be higher, I'd think.

Kurt Brouwer writes:

You wrote:

'..Because of our entitlement system, each of us is under the illusion that we do not have to save in order to meet our needs in old age. In the aggregate, however, this low saving is unsustainable...'

This comment seems to assume, inaccurately, that few Americans are saving separately for retirement. It also carries out the 'low savings rate' meme. As I understand it, our definition of savings does not include many retirement plan assets, nor does it include home equity.

If you include those items, our savings rate looks much better. Could you expand on this?


Mcwop writes:

I have the same question as Kurt. There is $2.38 Trillion in assets in defined contribution plans (includes the federal thrift savings plan, excludes IRA's). I believe the savings rate excludes DC plan savings from its calculations. Someone is putting money in those plans.

Bob Knaus writes:

I have to generalize from anecdotes, not evidence, as do the majority of people. Aggregrate enough of us and I believe you have something called a democracy.

Of all my acquaintences in their 30s and 40s, I cannot think of a single one who honestly believes he or she will get a dime from SS. My friends tend to be a little more liberal and better educated than average, although far less so than the average academic's acquaintences I'll wager. I'm pretty sure that more politically conservative citizens are just as skeptical of SS solvency. I'm not quite so certain about the less educated sector, but my guess is that they have low expectations of SS as well.

If my anecdotal evidence does in fact generalize to the 30/40-something population as a whole, then aren't we already seeing the maximum voluntary savings rate? Since none of us expect to get a dime back from the 15% of payroll that goes to SS, de facto we must be saving as much as we can for retirement, right? Now, experts may argue that it's not nearly enough, and I think many of my friends would agree with the math. But they won't save more voluntarily, because they can't. There are too many other pressing needs for our money right now.

Thus the attraction of shifting part of the SS tax to mandatory savings. Most 30/40 somethings would see it as a real boon, their own money in their own account that they or their heirs will eventually get. As for the impact on other savings, those outside of defined-benefit plans and home equity are so paltry for most people that we can safely ignore them. And the funding mechanisms for DB plans and mortgages are just as automatic as SS taxes for most people. So you'd see little impact on these kinds of savings.

Now paying for all this will require higher general revenue taxes. But look on the bright side - the tax exemptions on your 401k and mortgage interest are worth more! And even better, from a progressive viewpoint, by creating a 3rd major class of tax-exempt savings through SS privatization, we will have extended awareness of tax consequences down to the working poor! That is progress, right?

I realize that my arguments are behavioral, and not mathematic. If the consequent math pencils out, they are the sort of arguments that the mass of the electorate would find persuasive. If my arguments are based on bad math... then put some correct figures in front of me and I'll re-frame the arguments.

P.S. the main thing that struck me as "wrong" about the original article was the assumption that foreign capital markets were some amorphous blob, waiting to interact with our aging boomer population as needed. Aren't other developed nations facing similar demographic bulges? Don't they represent the bulk of the foreign capital markets? Won't they be under similar pressures to save and spend over time? Aren't we all in this same boat together?

Capt. Bob Knaus

spencer writes:

Could someone tell me what happened to our entitlement system in 1980 that caused peoples perceptions to change and caused the savings rate to start to fall.

In 1980 SS had been in place since the 1930s and the savings rate had been stable since 1950. After 1980 the savings rate started to fall. December related the fall in savings to entitlements, but if anything about 1980 is when entitelements peaked. If you look at the facts you find that since 1980 both entitlements and savings fell. How does this impact your thesis, december?

grigory writes:

The Federal Reserve has developed an alternative measure of saving that considers balance sheet changes, explained herein: "FOF [flow of funds] saving is computed as the sum of the net acquisition of financial assets and net investment in tangible assets less the change in liabilities; dividing by disposable personal income transforms the figures to a saving rate."

If you use this methodology, the savings rate was about 5% for the third quarter; not too shabby. But that sidesteps the larger point of household reliance on wealth and debt to fund consumption. Wealth creation is not guaranteed. While we have been fortunate the last two decades (the savings rate peaked in the early-80s and has followed inflation and interest rates down), what happens when rates begin to rise again? (Nominal GDP growth is higher than long bond yields for the first time since the early-80s, while household debt service and financial obligation ratios are near record highs...)

Phelps' conclusion rings true to me: "Once expectations are closer to reality -- once households expect a tax increase or a benefit haircut or both -- we will see significantly reduced consumption, thus lower imports, more output left for export, and a much weaker dollar. That is too bad. But the longer we wait to get back to reality the worse it will be. In denying the need for tax hikes or benefit trims, the government is staving off a further decline of the dollar at the price of requiring a greater decline later, once people catch on. For the excessive accumulation of foreign debt now will require a greater cutback of consumer spending in the future than what would have been required had expectations been correct all along."

Either way you slice it, no matter the savings rate, it comes back to a reduction in the trade deficit.

spencer writes:

If we see reduced consumption, and the associated rise in savings wouldn't that mean if everything else remains constant that the savings -investment gap should narrow. If the saving -investment gap narrows so would the current account deficit. If this is so why would the dollar continue to weaken. Shouldn't increased savings lead to a strong dollar, not a weak dollar. The main reason the dollar is weak now is foreigners are refusing to finance our growing twin deficits at current interest rate spreads. In an open economy the market clearing interest rate is the rate that atracts sufficient capital to finance the current account deficit with a stable currency.

David Bennett writes:

If by "entitlement system" you mean inflated real estate prices which people have been led to expect will go up and very optimistic hopes on the stock market which will finance their retirement you may be right.

If you mean social security most people are a bit pessimistic.

Those who believe the rightwing position also know (see Kudlow in the National Review for illustration) that tax vuts are about to launch an era of prosperity previously unimagined so problems along that line will go away.

There are of course other factors. Another one which can be blamed on capitalist trends is the state of mind created by the media which encourages hedonism and buying, indeed tying the very worth of the self to getting the things it "deserves." Note the rightwing position is most frequently to buy things to keep the economy going, it's patriotic to spend tax cuts.

Not that democrats, liberals and the forces of big government don't have responsibilities, but you're starting to sound like Ann Couter in your assumptions.

Very few people are spending beyond their means because they expect the welfare state to take care of them. You might also note (if you talk to them) that many are doing so somewhat desperately, they have been pushed beyond their means. In some cases this is because real wages have fallen, in others because symbols of wealth and consumption are considered social necessities, this is an attitude usually associated with a set of "conservative" values (you're no good if you can't take care of yoiur self and the more you have the better you are) though it's not absent in leftist Hollywood.

There are a huge number of things going on, including millions of Chrisians thinking we're near the end of the world, so why save? Yep they take those best sellers seriously.

For you to simplify the cause into one factor which just happens to be big government (surprise!) is exactly the same procustian society that exemplifies communism and other reactionary feudal approaches. I can only suggest you and your ilk go back to Russia, they do in fact have the flat tax (coincidence? you decide.)

Here in the United States we base our approach on pragmatism, a study of the actual facts, often contradictory in an exceedingly complex and disturbing trend. If you stay in this country you might want to learn our ways rather than making a hypothesis presented as fact that logically pursued shows that if it weren't for that dang social security our bank accounts would be full.

Rick Caird writes:

Tagging along on the later post for long term care insurance, my concern is that those of us who have paid into social Security for 35 years and saved for retirement will be told that our savings can sustain us and that we don't "need" social security. That effectively confiscates our Social Security for "the greater good" and discourages additional savings.


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