Arnold Kling  

Prescott, Time Inconsistency, and Social Security

Teacher, teach thyself economi... Social Security and Indexing...

Nobel Laureate Edward Prescott thinks that we need mandatory saving to solve a time inconsistency problem.

The reason we need to have mandatory retirement accounts is not because people are irrational, but precisely because they are perfectly rational -- they know exactly what they are doing. If, for example, somebody knows that they will be cared for in old age -- even if they don't save a nickel -- then what is their incentive to save that nickel? Wouldn't it be rational to spend that nickel instead?

The time inconsistency problem is that the government will tell people that they need to use their own savings for retirement, but then change its mind when it sees that people are destitute. Mandatory savings accounts are the solution.

Prescott makes the following rhetorical argument about Social Security reform:

if we could wipe the slate clean, what kind of government retirement program would we build from scratch today? ...I'm willing to bet that the best minds of both political parties, given such a charge, would not come up with a government retirement program as it currently exists.

For Discussion. If we could wipe the slate clean, would the best minds tend toward private mandatory savings accounts with restrictions on the instruments that could be used as investment vehicles?

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CATEGORIES: Social Security

COMMENTS (5 to date)
Mcwop writes:
For Discussion. If we could wipe the slate clean, would the best minds tend toward private mandatory savings accounts with restrictions on the instruments that could be used as investment vehicles?

Depends on what party is in charge. Republicans would probably favor private accounts. Democrats would probably favor something similar to the current system. I base this opinion on how each party currently speaks about the system, and how similar systems are viewed. Democrats speak about it as a government safety net, and Republicans consistently favor private accounts.

Now take health insurance, where we have a clean slate. Democrats favor (not all, but most) a more nationalized system, which will essentially be pay-as-you-go (see Hillary-care). Republicans favor something along the lines of private health savings accounts, with catastrophic insurance.

Boonton writes:

I can only speak for myself but if given an economy with a blank slate I would institute the following 'Social Security' program:

1. Payroll tax.

2. Mandatory private savings account.

3. When your account is large enough to purchase an annuity sufficient to guarantee a 'basic' standard of living in old age #2 will become optional. The payroll tax would pay for those who do not aquire enough assets for such a guarantee or those who become disabled and cannot work.

4. Borrow Arnold Kling's proposed reform of unemployment insurance. The money will go into a private account a person could tap any time they stopped working (whether they quite or are fired). This fund, however, would not count against their requirement to amass a sufficient retirement fund in #2

While some of my critics will say this a big shift from what we have now it really isn't. Now individuals build 'voluntary' nest eggs with 401K's and IRA's while the payroll tax is funding a combination of disability insurance, 'minimal retirement nest egg' and a little bit more.

Steve writes:

Prescott is ignoring another problem of time inconsistency. If the optimal plan right now is P then that too is time inconsistent. That is, whatever the optimal plan, be it private accounts, or some other scheme it too is time inconsistent and will be doomed to yeild a sub-optimal outcome.

For example, suppose the optimal plan is to use debt to finance a switch to private accounts. What could be the problem? If the debt financing goes off smoothly could the gov't then have an incentive to take on a new unfunded mandate of proportions similar to Social Security realizing that a debt issuance will solve the future problem? Forward looking debt purchasers then might balk at the initial debt issuance driving up the cost of issuing debt.

Here is another problem with a government run mandantory savings system. Currently with many 401k plans people can borrow against them. If people do that and are not wise with how it is used they could reach retirement with very little money and the government has to bail them out again.

The point is that very, very careful planning and hamstringing the damn politicians ability to tinker with programs has to be put in place with each and every policy. Hence Kydland and Prescott's conclusion of rules rather than discretion.

Steve writes:


You forgot the most important feature. Rules governing how those systems would work under different situations. Relying on discretionary policy will always lead to a time inconsistency policy unless you can successfully build a reputation.

Lawrance George Lux writes:

Boonton outlines the basic equivalent to the Chile Pension system. I would basically advocate the Norway system. Here are the relevant points, as I see them:

1) Public Finance cannot afford failure in the Pension system--therefore both individual decision to save, and instrument-choice in Investment must be denied to the Individual Worker/Retiree.
2)Annuities allow Insurance companies to make the same mistakes as Worker/Retirees in choice of investments--again to be avoided.
3) Pension taxation must be separated from overall Government spending--else there will be nothing saved and Pension system fail.
4) Business should be compelled to supply a mandatory Pension benefit(suggested one-quarter of Wages paid)by law, with legal stipulation of how the funds are to be invested(outside or exterior to Company instruments), Businesses forbidden to register Pension funds as Company holdings.
5) There should be no automatic COLAs, but Government to provide for a minimum subsidy where necessary.

It is not a good system for Retirement investment, but what is? lgl

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