Ageing and deflation in Japan

Inflation rates across industrialized economies have been remarkably low in the past decades, and at the same time these economies have been subject to considerable demographic ageing. Nowhere has this been more true than in Japan. What are the government's or the central bank's incentives to set policy that triggers lower inflation if the population gets older? I do not see where monetary policy would matter, but the fiscal theory of inflation may tell us something.

Hideki Konishi and Kozo Ueda study the latter in an overlapping generation model where the fiscal authority has a shorter lifespan than residents, but takes into account the impact of its actions on future governments. The fiscal theory of the price level tells us that inflation goes up when more debt is accumulated, and that is certainly the case when the population gets older and requires more retirement benefits. But the authors point out that this does not necessarily hold once you take into account the endogenous responses of income tax rates and public expenses. Then, because of the policy response it matters why the ageing is happening: lower mortality or lower fertility. Deflation is more likely in the former case. Now we just need someone to bring this to the data...

The elderly are not decumulating their wealth fast enough

According to the standard life-cycle model, you are supposed to accumulate assets while working and then decumulate them once retired. The optimal outcome is to die with nothing left, but bequest motives and uncertain lifetimes make that difficult. Still, assets should get reduced over time. Does this square with the data? No it does not, as the elderly cling to their wealth, especially their illiquid wealth such as housing, for which they make little attempts to extract any cash from, for example through reverse mortgages or annuities (previous posts I, II).

Agnese Romiti and Mariacristina Rossi try to understand why using European data on retirees. It turns out that financial literacy is a major factor here. Financially sophisticated households (identified by numeracy tests in the survey) have a more balanced portfolio, in particular with less illiquid real estate. They also make ends meet more easily, which the authors interpret as having a consumption path closer to optimal. Finally, they are actually decumulating their housing wealth, thus more likely to actively doing something about the illiquid wealth they are sitting on. As the paper is exploiting a data set that has several cohorts, it would be good to see whether the situation is actually improving, that is, whether younger cohorts do better.

Should firemen and police officers retire earlier?

Workers in some occupations get to retire with full benefits much earlier than others, for example firemen, police officers and jail guards. The justification is that they have dangerous or even life threatening occupations, and thus should be able to enjoy as much retirement as others. Does this argument really hold water?

Pierre Pestieau and Maria Racionero look at this question from the angle of optimal taxation and social security. Those with harsh occupations have shorter expected lifetimes (on average) and should be given early retirement by a utilitarian social planner so that they can consume more in early years. But the social planner needs to prevent the others from doing the same, and thus taxes heavily the savings of those in harsh occupations. Why would the social planner need to do this? It observes only the occupation, and thus has imperfect knowledge about expected lifetime. The worker knows better and can choose when to retire. Thus the issue the social planner faces is not that workers would choose the wrong occupation, it is rather that the workers who expect a longer lifetime would fake having a short one when they are in the harsh occupation.

Thus the paper is not at all about giving earlier retirement to people in harsh occupations. It is about giving that to people who expect to live a shorter life, using a signal from the occupation they are in, because it so happens that their is some correlation. It would be more interesting to see people sorting into those occupations once they learn what their expected lifetime is. To me this opens another question: if someone works in a dangerous occupation that has no long-lasting health effects expect sudden death (examples: police officer), conditional on having survived, should one still get early retirement? Probably not. But it matters when people decide what occupation to take.

Why is barely anyone buying annuities?

I have written before about the fact that so few people take annuities upon their retirement. While several reasons have been proposed, the literature has dealt with them in isolation, which is not very useful.

Svetlana Pashchenko addresses all suggestion in one swoop by using a quantitative life-cycle model with uncertain lifetime and medical expenses, bequest motives and minimum guaranteed consumption. Calibrated to the US, the model determines four equally important factor that prevent annuities from becoming popular: 1) pre-annuitized wealth (pensions), 2) minimum annuity size, 3) illiquid housing wealth, and 4) bequest motives. Pricing of annuities, interestingly, is not a factor. Adverse selection is responsible for making them more expensive than actuarially fair, while it decreases annuity demand for the poor, it increases it for the rich (as they know they will live longer and have cash to buy annuities). Note that 3) is another puzzle to me, as reverse mortgages are also rare, and they would render housing wealth liquid.

Japan's lost demographic decades

Since the asset bubble burst in Japan in 1990, the economy has stagnated despite significant policy efforts. Interest rates have been very low all along and fiscal policy has certainly not been austere. What was once labeled a lost decade has now become a pair of lost decades. Can only the burst bubble and the issues with the Japanese financial system be blamed?

Reiko Aoki thinks the demographic change in Japan has a large role in this extended stagnation. As is well know, Japan is aging considerably, and this has of course a dramatic impact of the savings picture. Financial institutions that were built to accommodate rapid growth and a young population looking to safeguard massive amounts of savings struggle to deal a much older population that is in the phase of eating its savings. Worse, as institutions need to adapt to the new situation, reform is hindered by the large voting block of the elderly whose interest lies in the short-term provision of their pensions.

Quite obviously, the current imbalance in the demographic pyramid is the problem. Aoki thinks that fertility must be encouraged. This has worked little in other economies, but may be much easier to implement politically than the best solution, get people to retire later. Immigration is another solution, but as other countries are looking to embrace similar solutions, we may run out of willing young migrants. And Japan is not the obvious choice for a migrant, given the high entry cost in terms of integration.

Does the retirement age have an impact on when you die?

Being active in old age is thought to improve life quality, health and ultimately longevity. My grand-father painted and played brain games until late in his life, and made it to 92 really enjoying his last years. But beyond such leisurely activities, working also keeps you active. Does retiring later also prolong one's life? Answering that question is not straightforward because of the reverse causality. One may be able to work longer because one is of better health and thus will live longer. And of course, those who die early may also have retired early due to health reasons.

Erik Hernaes, Simen Markussen, John Piggott and Ola Vestad look at Norwegian administrative data and find no relationship between retirement age and mortality. To avoid the endogeneity issues, they exploit the fact that the retirement age was gradually decreased for some employers. The study also takes into account that employees may have switched jobs because of these changes. They check on the impact of the actual retirement age on mortality instrumenting with the entitled retirement age, and no matter the controls there is no relationship. So it looks like being active only has an impact on the enjoyment of life in the latter years.

Imperfect substitution between pension wealth and savings

In a perfect world, forcing people to save through some pension fund would not make a difference. Pension and private savings would be perfect substitutes. Empirical evidence does (mostly) not corroborate this. The introduction of mandatory pension funds increases savings. This could be because people did not want to save that much, but that would mean private savings would be very small, which is not the case. Other options would be that people face some constraints in savings that are relaxed with pensions, namly return risk, voluntary bequests, borrowing constraints and most importantly mortality risk.

Zhiyang Jia and Weizhen Zhu build a life-cycle model that includes all these market imperfections and then bring it to the data, namely calibrating it to Norwegian household data. Comparing simulations with and without market imperfections, it turns out that the empirical departure form the perfect world are well explained. In other words, we have a good model of life-cycle savings, and if necessary we can make it match particular features of the data.

Do the Greek retire earlier because of their occupations?

A common complaint within the current acrimonious debate about the Greek debt situation is that the Greek retire much earlier than, say, the Germans. This is considered unfair, and the Greek should not enjoy such privileges. It is, however, a fact that people in different occupations retire at different times, and Greece may simply have a labor force with an occupational compositions that yields a lower retirement age. If this were the case in a magnitude corresponding to the observed differences in average retirement ages, the criticism would not be warranted.

Philip Sauré and Hosny Zoabi look at this in the following way. They take the retirement age by occupation for males in the United States, then apply this to the occupational composition of 28 OECD countries. Looking at the effective average retirement age, it turns of occupational differences can explain about 10% of the cross-country variation. Add in another 10 non-OECD countries, and you explain about 16%. Not huge numbers, but occupational composition matters. Transforming the data to account for category mismatches and the impact of state pension plans, one can explain 28% to 39% of the variation, though.

And, by the way, the effective age of retirement of males is higher in Greece than in Germany.

Why the rich save more

It surprises no one that the rich save more. But they save even more than what could be accounted for the lower propensity to consume that one would get from any reasonably parametrized model. What could account for the difference?

Annamaria Lusardi, Pierre-Carl Michaud and Olivia Mitchell that survey evidence tends to indicate that the rich are financially more literate, whereby the direction of the causality is not clear. They build a life-cycle model where financial literacy is endogenous. The mechanism generating higher savings is interesting. As the rich get retirement benefits that are relatively small compared to their permanent income, they need to have more precautionary savings. To manage these savings, they get more financially literate. This allows them to get higher returns and get even richer, while those that are content with their public retirement package see no need to save more and learn how to get better returns. One more reason to improve economic literacy in the public.

Social security and the increase in US health care costs

Health care expenditures increase faster than inflation, and I have already offered several explanations for that. But there are more, and they work in rather subtle ways. Today's theme is social security.

Kai Zhao builds a large general equilibrium overlapping generation model to quantify the impact of the introduction of social security in the US on health expenditures. And it is substantial, at 43% of the increase since the fifties. How can this happen? One mechanism is that social security transfers income from the young to the old, and the old have a much higher propensity to spend on health. A second one is that with social security, the utility during retirement years is higher, and thus people want to make sure to have more of those years. Interestingly, the depressing impact of social security on capital accumulation is far too small to counteract the first two effects.

Miss sharing with future generations? You are not missing much

Markets are not complete. Two major ways in whuch they are not complete is that we have borrowing constraints and that we cannot exchange with future generations. The latter can be a big deal when we think about the valuation of future amenities (like the environment) or long term risks. In particular, future generations could make us behave in certain ways if they could influence some of today's markets. This is precisely why the overlapping generation literature emerged, and a principal conclusion of it is that the government needs to intervene, in particular by providing an security that lives beyond generations: the government bond. While there is obviously a welfare cost to the lack of future generations on current markets, how large is it? The literature tells us the welfare benefit of the government bond is large.

Roel Mehlkopf just defended a dissertation on this topic, focusing on risk. In a nutshell, the cost is not that large, and it all has to do with distortions on the labor market. For one, those you ex-post need to transfer to another generation face a commitment problem in the sense that they want to reduce their labor supply, for example by retiring early. Once you take this into account, there is little to redistribute, and it can even be welfare-decreasing to transfer. This rationalizes why pension funds needs to be solvent at all times, even if they are solvent in the long run. One important implication is that when cuts are necessary in pensions, they should be larger for the young workers, as this reduces the labor market distortions.

Also, the dissertation points out that comparing to a situation with fictitious markets between non-overlapping generations can be misleading. Indeed, this implies that they all have the same weight in a social welfare sense. But there can be good reason for a social planner to deviate from this, and the analysis above, fr example, implies that future generations benefit more from risk sharing than current ones (who are at least partially locked in by past decisions). This should entice the social planner to give more weight to current generations, even beyond normal discounting of the future. And as only current generations for for the current government, we are not far from that optimum.

Make social security contributions more visible

Any tax on labor income reduces the labor supply depresses the labor supply, this is no secret. Theory also tells us that whether the employer or the employee pays any withheld tax does not matter. Contributions to pension plans, which are typically paid by both employers and employees, look like a tax on the pay stub and should thus obey the same principle. Well not quite.

Iñigo Iturbe-Ormaetxe argues that the size of the pension fund contribution says something about the future benefits. If the employer contribution remains hidden, the employee is not aware what great benefit he is getting. Were he to pay the whole contribution, after a corresponding pay rise that is revenue neutral to the employer, the employer would be happier about his pay and would increase his labor supply. It would work similarly if the employer would simply indicate on the pay stub her contribution. This assertion is backed with a crude cross-country regression of employment rates in the OECD which shows that at least male employment rates a negatively affected by employer contributions, but not by employee contributions.

Sustainable retirement pension reform?

With increasing longevity, it is obvious that something needs to be done to keep pension systems around the world sustainable. The main options are postponing the normal retirement age, lowering retirement benefits or increasing contributions. The typical studies that compare these options and are thrown around in the public arena are done by accountants and actuaries, who do not take into account the changing incentives of market participants. Economists can do better.

Peter Haan and Victoria Prowse take up the challenge and estimate a very complex life-cycle model for Germany. It includes idiosyncratic risk, consumption and labor supply decisions and a complex tax structure. They find that the 6.4 year increase in life expectancy over the next 40 years needs to be met either by an increase in the full-pension age by 4.3 years or a reduction of benefits by 38%. The first approach markedly increases the unemployment rate. This is ironic in Europe where a reduction of that age is typically viewed as a way to reduce chronic unemployment among the young. The other option would markedly increase savings, as people have to fend for themselves more. Consumption of retirees is higher in the first option though.

Am I satisfied with this study? It is much better than what you typically see, yet I want more. The easy bit is that one could actually determine whose welfare increases under which option. That could help in understanding the (political) feasibility of such reforms. And maybe a combination of them turns out best. More critically, the model does not attempt to consider the consequences in the changes in aggregate supply. Lengthening the work age this much increases the work force dramatically and must have consequences for aggregate, and thus individual, wages. Also, while the matching probabilities and wages of retirement age workers are estimated from current data, I do not think these estimates apply once more previous retirees are forced into this pool. The new ones have different qualities compared to those who would have continued working anyway. Therefore, I see more work to be done.

Public pensions are not sustainable, even in Norway

By now, everyone must be aware that populations are getting older and that this puts some serious strain on pension systems. Unless one plans far ahead or is blessed with substantial sustained growth, some problems in financing retirement will appear. But there must be some place that is going to do fine, say a country with a forward-thinking government, a recently reformed pension system, a well managed endowment of natural resources and a small and smart population, like Norway. Right?

Wrong, say Christian Hagist, Bernd Raffelhüschen, Alf Ering Risa and Erling Vårdal. To come to this conclusion, they use generational accounting, which measures the fiscal sustainability of the public sector and in particular the publicly funded retirement pensions. The latter went this year through a significant reform, which includes pension indexation below wage growth, benefits adjusted to be actuarially fair if life expectancy increases further, and work incentives for elderly. It turns out the pension reform has helped substantially for the sustainability, about as much as the presence of the endowment of oil and natural gas. But that is not going to be enough, even with higher oil prices and an exceptionally well managed petroleum wealth. And for those hoping that future growth of the economy or higher fertility would help, well at least in the case of Norway this would barely help. To close the gap, a 17% increase in taxes would be needed, and they are already very high in this country. So, if Norway cannot make it, how could countries with inactive governments and little or poorly managed endowments make it?

How to compensate the short-lived

It is very unfortunate if you die early, and knowing this it would be optimal to compensate you for this misfortune. But this is difficult to achieve as your death is not predictable, and compensation after death is not very helpful to the deceased.

Marc Fleurbaey, Marie-Louise Leroux and Grégory Ponthière have figured out a scheme that would achieve this. First, they need to define a social welfare function that would make it desirable to compensate people for shorter lives. Second, they find a policy that would achieve such a compensation. The policy is to essentially cancel social security while putting the mandatory retirement earlier.

Basically it is all about getting people to consume early, so that the different between being dead or alive is not that large later in life. This seems very difficult to achieve given that life valuation studies indicate that people value life at a multiple of consumption. Furthermore, if we discourage people from saving that much, this must have large negative consequences for the accumulation of capital in a macroeconomic sense, something that has been neglected here, and should not.

Public pensions should not be fully funded

Many governments are currently struggling to fund the future liabilities stemming from the retirement benefits of their civil servants. For many of those, the fact that they are significantly falling behind, especially as those funds lost value during the crisis, is seen as a very serious problem that could jeopardize those commitments and/or lead to significant tax hikes. But is this really a problem?

Henning Bohn claims that it is not necessarily so. First, most taxpayers are debtors, thus they would prefer not paying taxes now for future pension payments, as they discount at their borrowing rate, which is higher than the return of the pension funds. The violation of the Ricardian Equivalence thus stems from the intermediation costs. This means that governments should actually not fund at all their future pension liabilities. The only exception may be if they need those funds for collateral, which may be quite important in the case of sovereign debt, as I reported recently.

Men last longer

Women live longer, yet paradoxically they can claim pension benefits earlier in many countries, where there is strong resistance to equalizing the retirement age (let alone increasing it, see last week's post). Would true believers in markets and efficient politics still find an explanation of this paradox?

Wolfgang Maennig and Michael Stobernack offer one: the physical performance of men declines much slower with age than for women. They base this on the worldwide top performers by age on rowing machines. The latter are of uniform quality, thus environmental factors do not matter and everyone competes on level ground. This is better than previous studies relying on track-and-field records, that more susceptible to whether influences (and doping). From the 40's to the 60's, the physical performance of men declines by about 15%. This is less than the productivity decrease that would be implied from wage changes (and labor productivity does not depend solely on physical performance, one could think older workers have in fact better non-physical qualities like experience). For women, this is more in the order of 20%. The difference is even more pronounced for those in the "lightweight" category.

The study does not go beyond the 70's (and I suppose the records pertain to the younger ones among those). So it must be that at some point the men start declining really fast. It also be that the age differences among the best rowers are simply not representative of the age differences among the general population. These elite athletes maintain their body, whereas the general population may not, and especially there may strong gender differences in doing so.

Why Greece will never make it: self-fulfilling expectations about social security

Mediterranean countries have many things in common, one of them is an early retirement age. You certainly read about the uproar when the Germans learned that they had to bail out the Greeks who enjoy retirement many years earlier. Now there is much pressure on Greece to lower and delay pensions, but there is tremendous resistance from the street. The same is happening right now in France as well. Yet, initiative to delay retirement in Northern Europe or North America, where retirement age is already higher, do not generate much discussion.

Ryo Arawatari and Tetsuo Ono may have an explanation for this dichotomy: self-fulfilling expectations. The story is very intuitive. If you expect pensions to be generous, there is no point in accumulating savings for retirement, and you do not invest in education either. And once you are low skill, you will vote for generous pensions. The opposite happens with expectations of small pensions. And once you are in such an equilibrium, it is very very difficult to get out of it: people want generous pensions, and the newcomers know this and thus expect this not to change, and make the appropriate (non)investments. To change this, you need to massively lower expectations during a whole generation or more. No Greek government can have that much staying power. And neither does the French one.