The Capital Critique in Pension. Saving, Investment and Growth in the Debate on Pension
03/11/181
The Capital Critique in Pension. Saving, Investment and Growth in the Debate on Pension Reform.
Sergio Cesaratto
Department of Political Economy
University of Siena
Paper prepared for the Conference on Economic Growth and Distribution: on the Nature and Causes of the Wealth of Nations
Lucca 16-19 June 2004
(first draft)
Abstract
This paper will show the relevance of Keynes’ paradox of thrift, reinforced by the controversy on capital theory suggested by Sraffa, to on three themes related to the current debates on pension reforms. Keynes-Sraffa’s criticism is indeed particularly biting with regard to the relation between saving, investment and output which is central in the pension debate. The paper is critical not only of the neoclassical approach, but also of some positions expressed by less orthodox economists. More specifically it is argued that: (i) A reform aimed to create a Fully Funded (FF) pension scheme (based on the accumulation of real assets), even if successful at raising rising the marginal propensity to save ( which what should not be taken for granted), would fail since, according to Keynes-Sraffa’s criticism, it does not follow that the larger potential saving supply is necessarily translated into an increased amount of investment (more precisely in a higher per-capita capital endowment). (ii) This is also true in an open economy: the criticism of neoclassical capital theory and the theory of effective demand also dispose of the conventional idea that a higher saving supply from the northern countries will naturally flow to the capital-poor southern countries stimulating investment there. In this light, it is surprising to hear listen from less mainstream oriented economists that if a country opts for pension funds, the risk is that savings are ‘exported’ instead of being invested at home. The risk is just deflation at home. (iii) A more sympathetic view to a FF pension reform is expressed by Foley & Michl who base it on a ‘Classical growth model’. However, their support of a transition reform towards a FF scheme does not appear analytically robust since it lacks any plausible saving-based explanation of accumulation (alternative to the neoclassical one that, after the capital controversy, has to be rejected).
Introduction[*]
The saving-investment nexus is central in the pension debate, an important aspect of which concerns the impact of the different pension schemes, unfunded or funded, on economic growth. The dominant, neoclassical approach considers transfer-based pay-as-you-go programs (PAYG) as injurious to capital accumulation and favours the adoption of saving-based fully funded schemes (FF) that would instead encourage it. An alternative approach (let us label it ‘Classical-Keynesian’) based on the extension to the long period of the Keynesian postulate of the independence of investment from saving regards PAYG as favourable (or at least neutral) with respect to accumulation and any reform aimed to encourage saving as detrimental to aggregate demand and growth. This approach is based on Keynes’ paradox of thrift, reinforced by the controversy on capital theory suggested by Sraffa which, as we shall see, is valid both in the short and in the long run, in a closed as well as in an open economy.1 A third view, based on a ‘Classical growth model’ is more sympathetic to a FF reform by taking investment as determined by saving presumably assuming the validity of Say’s Law at least in the long period.
Section 1 will summarise some results of the attempt conducted by a number of Sraffian economists to reinforce the implications of Keynes’ theory of effective demand for the explanation of accumulation (that is with regard to the long period) in a direction that, however, is divergent from that taken by the economists that work in the tradition of Joan Robinson and Pasinetti.[1] SectionPasinetti. Section 2 will single out the nature of autonomous expenditure of PAYG’s transfers in the theory of effective demand. Section 3 will criticise the proposal of a wider adoption of a FF scheme based on a ‘Classical’ growth model stance advanced by Foley & Michl. Section 4 will cast-off the feasibility of an analogous proposal based on the neoclassical growth model. The two final sections will consider the saving-investment nexus in the pension debate in the open economy. Section 5 rebukes the mainstream argument that investment in the Southern countries or the mechanism singled out by the Theory of Endogenous Growth are such as to preserve assure the profitability of a larger amount of old-age saving. Section 6 will consider the preoccupation expressed by some critics of FF reforms that these are bad because the pension funds would ‘bring take (I think you mean take) domestic saving abroad’.
1. The short and long period theory of Effective Demand
In his General Theory, Keynes showed that, within the limits of full utilisation of output capacity, a larger amount of investment does not require a prior reduction in consumption, and that the higher level of output and income generated by the greater utilisation of capacity generates savings equal to decisions to invest. Michael Kalecki proposed a similar approach. The ‘Neoclassical synthesis’ limited this mechanism to short-period situations of low business and financial confidence, arguing that in those circumstances active fiscal and monetary policies were required to reach full employment. This was the conventional wisdom until, in the late 1960’s, the Monetarist revolution began to reaffirm the pre-Keynesian doctrines. Although the ‘new classical economics’ subsequently receded, the currently prevailing conventional wisdom still fundamentally reflects pre-Keynesian views. In the meantime, however, a number of non-orthodox economists have tried the opposite strategy of extending Keynes’ analysis to the long period. Accordingly, in the long run (when productive capacity may vary considerably), even more than in the short term, investment is independent of, and, indeed, determines saving through, increases in output.[2] Thus aggregate output is determined by effective demand, defined as aggregate expenditures forthcoming at normal prices of production.[3] (You use ‘period’ , ‘run’ and ‘term’ all in three lines. Which one do you mean as they are each associated with some theoretical position)
According to the theory of long period effective demand the engine of growth is represented by the autonomous or final components of aggregate demand, those components that do not depend on the actual or expected level of real income generated by firms’ decisions to produce. These include autonomous consumption, government spending and exports. Cesaratto et al. (2003) have argued that gross investment should be excluded from the autonomous components and rather be considered as induced by expected demand.[4] Autonomous expenditure embraces also social transfers from the State that contain PAYG’s pension payments. Far from being a mere transfer of income, the theory of long period effective demand regards the payment of pensions as an autonomous decision to spend by the government, as shown below. In the meanwhile, it should be appreciated that in the Classical-Keynesian approach social spending can represent an engine of growth, so that there is no necessary contradiction between greater social equity and growth.[5] Welfare State expansion, although favourable to stable economic growth may however encounter an obstacle in the political acceptance of distribution changes – for instance higher taxation on profits - by the most affluent classes. In post-Second World War historical conditions the Western economies accommodated this expansion, but since the late 1970s the distribution role of the Welfare State has been under constant attack (although at the price of weaker and more unstable growth). By contrast, in the Marginal theory the contradiction between ‘equity’ and ‘efficiency’ is more mechanical. For instance, according to this theory, pension transfers diminish disposable income and may reduce savings decisions and accumulation.
The rescue of the long-period implications of Keynes’ theory of effective demand is reinforced by Sraffa’s criticism of the Marginal capital theory. This criticism undermines the very possibility of deriving the demand curves for factors in a rigorous and general way. This derivation relied on two alternative mechanisms (e.g. Solow, 1970, ch.1): (a) direct factor substitution in production; and/or, in the case there are fixed production coefficients, by (b) indirect factor substitution, which operate through adjustments in the composition of consumers’ optimal consumption baskets in response to relative price changes. Sraffa not only showed that they have analytical flaws, but also suggested that these substitution mechanisms were absent in the Classical approach. This stimulated the controversy surrounding the neoclassical theory of capital in the 1960s and 1970s, which refers precisely to the analytical plausibility of the decreasing ratio between demand for factors and their remuneration. (cf. Garegnani, 1990).There are two refs to Garegnani 1990 in the bibliography
The first substitution mechanism predicts that when, for instance, the wage rate falls, more ‘labour intensive’ methods of production will become more profitable and labour demand will rise. The controversy has shown that when there are a multiplicity of techniques and more than one type of capital good, the possibility of reswitching techniques undermines this neoclassical prediction (Sraffa, 1960, pp.81-84; Garegnani, 1970). Indirect substitution by reshuffling consumption is also precluded. According to marginalist theory, a fall in the relative price of any factor leads to a fall in the relative price of and a rise in the demand for the goods in the production of which the factor is used relatively more intensely. But as the real wage varies from zero to maximum, the price of any commodity A produced using a given technique may alternately fall and rise with respect to the price of another commodity B, produced using a different given technique, so that no a priori expectations as to the direction of the change, based on the ‘factor intensity’ in the production of the two commodities, are justified (Sraffa, 1960, pp. 37-38).[6]
This criticism is damaging both with regard to the marginalist theory of distribution, based on the simultaneous determination of the rate of profit and of the wage rate as reflecting the relative capital and labour scarcity; and with respect to its theory of output and employment, based on the tendency towards full employment of both capital and labour - with the sole proviso that the financial and labour markets are competitive enough not to obstruct the full adjustment of factor demand and supply. If the Classical approach provided Sraffa with an alternative distribution theory, Keynes’, Kalecki’s and (the latter) Kaldor’s criticism of the neoclassical theory of output and employment have been taken as the starting point for the construction of an alternative theory of capital accumulation.
- Pensions, effective demand and economic growth
According to prevailing wisdom, the creation of a PAYG system is tantamount to an original and reiterated sin: potential savings out of viz. wage growth that could be used for capital accumulation are wasted in sustaining the old generation. [7] This was not the prevailing view in the US and other countries at the time of the inception of the public pensions programmes, well into the middle of the Keynesian revolution. In those times the dominant view was that social transfer programmes were not only beneficial as such, but also favourable to effective demand and accumulation. This reflected Keynes’s view that ‘measures for the redistribution of incomes in a way likely to raise the propensity to consume may prove positively favourable to the growth of capital’ (1936, p.373). Beveridge (1942) viewed full employment as a pre-requisite for the Welfare State. This view took a more explicit Keynesian flavour in Beveridge (1944) in which social transfers were seen as a policy instrument for reaching full employment. Beveridge regarded ‘State action in re-distributing income by measures of Social Security, and by progressive taxation’ as favourable to the growth of ‘private consumption outlay’ (1944, p.30), since ‘the income provided by the scheme to persons who are sick, unemployed, injured or past work, will almost invariably be spent to the full’ (ibid, p.160).[8] In 1943 Metzler drew a distinction between the ‘Investment Multiplier’ and the ‘Redistribution Multiplier’. The latter referred to the effects of a subsidy levied on the ‘low propensity to consume group’ in favour of the ‘high propensity group’. Subsequent discussion intertwined with that of the famous Balance Budget Multiplier. In this debate PAYG transfers were considered with greater clarity as an autonomous expenditure. When, one year after Metzler’s contribution, Wallich published his important paper on the ‘Income-Generating Effects of a Balanced Budget’[9], he started by taking as ‘generally assumed that the income-generating effect of a balanced budget depends upon its “progressiveness” i.e. upon the extent to which taxes and expenditures lead to a redistribution of monetary income from high-saving to low-saving groups and thus to a rise in the average propensity to consume’ (1944, p.78). The Balanced Budget Theorem actually set out to show that economic expansion was possible with a balanced government budget, even with a ‘non-progressive budget’. The analysis was reconsidered later by Musgrave (1945; 1959, chap. 18), who pointed out that a full employment policy based upon the Balanced Budget Theorem could take place either through an increase in public expenditure, or by an increase in public transfers that take advantage of the differing marginal propensity to consume of different income groups, those taxed and the beneficiaries of the transfers.
Suppose that, in a closed economy, the transfer beneficiaries have a marginal propensity to consume equal to higher than the marginal propensity of income earners c. Using a standard textbook notation, if transfers are increased by and taxation by , we have:
, that is:
(1)
which is positive.[10]
In the case of pension transfers in a Balanced Budget context, the actual value of the multiplier may be assessed in the light of the empirical circumstances that in each historical period govern the propensity to consume of the various social groups. It may be thought that the propensity to consume of retirees is higher than average, but not necessarily higher than the labour classes, and if the system is financed precisely by payroll taxes on the latter’s incomes, then the value of the multiplier may be small. Progressive taxation would tend to increase the value of the multiplier. If pension transfers are financed out of deficit spending, of course, they would generally have a positive effect on Effective Demand. Given the expected low value of the Balanced Budget Multiplier in equation (5.1), deficit financing appears to have more marked income-generating effects.[11]
Only later, during the Monetarist revolution of the seventies, following the seminal contribution by Feldstein (1974), did PAYG begin to be seen as detrimental to capital accumulation, since workers would interpret contributions as a substitute for private savings whereas the olds consume most of the transfers they receive.[12] For instance, in his classic paper, Feldstein remarks that: ‘The evidence presented in this paper seems ... consistent with the Keynesian view that the aggregate saving would increase as income rose if there were no offsetting government policies’ (1974, p. 922), that is payroll taxes (‘offsetting government policies’) would crowd out net saving out of rising wages. This suggestion is picked up, for instance, by the World Bank which states: ‘suppose the government introduces a mandatory pay-as-you-go old age security plan that requires young people to contribute payroll taxes (equivalent to their previous saving) to the plan and pays them a pension (equivalent to their previous dissaving) later on. Introducing the system reduces national saving initially, because the first group to benefit from the program … receive a windfall gain. …fewer resources are left to be saved and invested during the initial period, permanently reducing capital stock and national income’ (1994, p.307). The Bank, however, is forced to conclude that: ‘Despite the logic of this argument, numerous empirical investigations (…) have been unable to prove conclusively that saving did, indeed, drop once pay-as-you-go programs were established’ (ibid).[13]
To sum up, in the theory of Effective Demand, pension transfers are an autonomous component of Effective Demand that, either by changing income distribution in favour of the social groups characterised by a propensity to consume higher than those who are called to finance them, or by being deficit-financed, may positively affect the level of the social product. Only in the case that the propensity to consume both of the beneficiaries and of the contributors is the same, and the social security budget is kept in balance, do PAYG pensions appear as a mere transfers without any effect on the level of National Income. On From the opposite view, according to the dominant theory PAYG’s transfers may displace saving and investment, but the relevance of this displacement effect is questioned even by mainstream economists. Anyhow, the results of the capital controversy give us enough self-confidence to rebut the neoclassical stances and reaffirm the Keynesian interpretation.
3. A ‘ Classical’ model of FF reforms
The Classical economists were quite open to diverse approaches to the theory of accumulation (Garegnani, 19834, pp.24-28). In particular, mechanical forces leading to full employment are not to be found either in Ricardo or in Marx. Ricardo believed in Say’s Law, which was instead rejected by Marx. The Long Period Theory of Effective Demand suggested above combines the rejection of automatic tendencies to full employment with the rebuff of Say’s Law (basing this rejection on Keynes, Kalecki and the results of the capital controversy rather than on Marx). An alternative stance combining the rejection of automatic full employment but accepting Say’s Law is pursued by Foley & Michl (2002; 2004; cf. also Michl, 2001) who apply it to the pensions issue. In orderwWe shall consider Foley and Michl’s (F&M for short): (i) distinction between Classical and neoclassical theory, (ii) their ‘Classical’ model, (iii) their social security reform proposal and, lastly, (iv) the role that they attribute to macroeconomic policy in the contexst of the reform in this order.