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Sunday, March 06, 2005

Social Security and Saving

When the government issues new debt, it seems to me that there are three possibilities to consider (assuming it is not monetized):

1. The resulting rise in interest rates causes saving to increase and consumption to decrease. Thus, one possibility is the textbook case of saving increasing because interest rates rise.

2. The fall in the price of T-Bills (rise in the interest rate) causes a movement away from substitute assets into T-Bills. There is no net effect on saving.

3. The T-Bills are purchased by the foreign sector. [The experience of the EU may be relevant (see Krugman and Obstfeld page 306, 6th ed.). In that case, a reduction in the deficit had almost no effect on national saving as savers decreased private saving to compensate. Thus, the twin deficits prediction of an increase in the current account surplus failed to materialize. As K/O note, one explanation for this is Ricardian equivalence, but it is not likely the full explanation as the empirical evidence suggests Ricardian equivalence only holds in part. K/O point to increases in household wealth as responsible for the remainder of the fall in private saving. ]

4. If households are led to believe (incorrectly and therefore irrationally) that privatization will increase the expected assets available to them at retirement, saving will decrease. I will assume rationality will prevail in the end.

Then there is risk to consider:

1. Since the government's obligations are reduced under privatization and replaced by an inflow from the stock market, people may perceive a reduction in the risk of the government meeting its obligation to pay retirement benefits. Government payments are more certain since the obligation is smaller. This reduces risk and reduces saving.

2. Since individuals are now participating in the stock market, they face more risk. This will increase their saving.

Thus, the net effect depends on people's perception of the change in risk. There is more risk from being in the market, but less risk of government default. The effect on saving depends upon the individual's perception of how these risks change.

So, it seems like the overall effect is an empirical question - it depends upon relative magnitudes, and one of the influences is difficult to measure as it depends upon people's perception of changes in risk.

I've been trying to fully understand the savings debate I'm reading. With the above as a reference point, what have I left out or stated incorrectly? What other forces affect saving, or cancel the effects noted above?

    Posted by on Sunday, March 6, 2005 at 02:25 PM in Economics, Saving, Social Security | Permalink  TrackBack (0)  Comments (0)

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