Funded vs. Unfunded
The Economist recently had an in-depth special report on pensions, but one confusing statement stood out:
In a sense, it does not matter how the benefits are paid for. If unfunded, they come from workers’ taxes; if funded, they come from investment income.”
What did they mean by it, and are they making sense?
I would interpret their point as implying that that in the end, there has to be a transfer of value from younger generations to the baby boomers: retirees consume, workers save and produce (or borrow from the rest of the world, I suppose). Ignore the names for things like government, taxes, equity, debt, and focus instead on actions and real movement of goods and services. Youngsters work and pay for oldsters – the question is how we get there and what the economy looks like, the degree of coercion needed to accomplish this intergenerational transfer, and whether it will be stable or not, optimal or unsustainable, etc. On this aspect the Economist’s simplification is unforgiveable. The actual implementation and incentives matter a good deal, of course. It is much better to save and invest, and have a bigger stock of productive capital later on, then consume like crazy, save nothing and then try to tax the hell out of your kids to pay for retirement.
The late, great Paul Samuelson illustrated the economy in a label-free way (if you want to read one paper to see economics at its best, this might be it: http://economics.uwo.ca/grad/9603a001/papers/Samuelson1958.pdf) – a metaphor is imagining a tribe of intelligent monkeys on an island who eat cocoa. Young monkeys can climb up and eat the chocolate. But once they get too old, they starve. Not good. Eventually, older monkeys establish a social construct/government/central bank that exchanges pink seashells for chocolate. Youngsters accept seashells so that they can have a pension to cash in when they’re too old to climb trees. Life is better, though more complicated. What to call this improved system? Can it too become unsustainable?
Regardless of what path the economy takes – what equilibrium prevails – birds (nonedible ones) perched in the cocoa trees will take notice. They’ll no longer hear the moans of starving geezers or watch the young pelt the old with candy wrappers. But while the birds will all agree about the amount of chocolate being passed from the young to the old each period, they’ll vehemently disagree as to the policy in place. Some birds will claim that monetary policy is at work and that the shells are money. Others will see a pay-as-you-go social security system in which the chocolate handed over when young constitutes a tax and the shells simply represent bookkeeping for one’s future claim to chocolate social security benefits. Yet others will claim the shells are bonds that are purchased when young and sold when old. And there will even be some birds who’ll claim that the shells are irrelevant – just a shell game, if you will – and that the chocolate eaters must have drawn up a constitution forcing each generation of young to make transfers to the old.
After the birds spend several centuries arguing and forming societies called the Monetarists, the Socialists, the Keynesians, and the Strict Constructionists, a young bird named Paul points out that the argument isn’t about economics, but about language. This stops the fight for a full nanosecond, after which it proceeds apace. (http://sws1.bu.edu/kotlikoff/Samuelson.pdf)
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