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July 26, 2005

The Economic Framework for Flourishing Pensions
by Andrew Smithers

Talk at Politeia in London.

Stating the Issue.

The economics of the pension debate seem to me to have been bedevilled by confusion between household and national savings. This was illustrated by the First Report of the Pensions Commission ("FRPC"), which presented three solutions to the perceived pension problem. (i) Taxes or national insurance contributions devoted to pensions must rise. (ii) Savings must rise. (iii) Average retirement ages must rise.

These were presented as if they are independent choices, which they are not. If we have a pensions' problem, then national savings must rise. Furthermore if a rise in national savings can be assured, it will only be possible if fiscal policy is subordinated to that aim.

The issue can therefore be put into four parts: (i) What does a pensions' problem mean? (ii) Do we have one? (iii) Can it be solved? (iv) If so, how?

What Does a Pension Problem Mean?

A pension problem, for a nation as much as an individual, lies in whether we save enough to meet our expectations about retirement incomes. If the answer is no, we must adjust either our savings or our expectations. If we don't, we will be faced with grief. This is likely to take the form of disappointment and relative poverty for an individual and social strife for a nation.

Do We Have A Pensions' Problem?

This depends on our expectations. It is thus a political rather than an economic issue. Nonetheless, it seems clear to me at least that British voters do not favour a relative decline in the living standards of the elderly. I think that it is also highly probable that this cannot be avoided at our current level of savings. If these two assumptions are correct, then we do indeed have a pensions problem.

Can it be Solved?

The answer is almost certainly yes, provided that the rate of national savings rises. This is clearer for an open economy than a closed one. In the former case there is no need for the growth in GDP to accelerate. A rise in UK savings which was sufficient to offset our current account deficit would reduce living standards by 2 to 3% p.a. in the short-term, but would increase our available resources by around 60% of GDP over 15 years.

It is worth pointing out that this will not increase the net ownership of international assets by the UK, it will merely prevent the large increase in our net debts that would, on the same assumptions, otherwise occur.

A reduction in the growth of net foreign debt is not, however, possible for the world as a whole. The problem of preserving the relative living standards of the elderly is nearly universal and more pressing in the Eurozone and Japan than it is in the UK. If a general solution is to be found, higher savings' targets by individual countries are not a sufficient solution for two reasons. The first is that a rise in investment is a necessary condition for a rise in savings in a closed economy. The second is that this rise in investment must, but will not necessarily, lead to an acceleration in the growth of world GDP.

I will postpone for the moment a consideration of the problems involved in raising savings in a closed economy. In practical terms, the UK can only deal with its own problems, and as a relatively small part of the world economy, it can increase its savings without the necessity of either increasing domestic investment or running a current account surplus.

How.

National savings are the sum of the savings of different sectors of the economy - households, companies and government. A rise in the savings of any one of these sectors alone will not be a sufficient condition for a rise in the total. For example, a rise in the household savings rate will have no effect on the total if it is offset by either a rise in the budget deficit, or a fall in business savings. The only one of these which the government can control is its own budget balance. It follows that two conditions have to be satisfied for a government determined rise in national savings to be achievable. First, the fiscal balance must be set at a level which meets the national savings objective. Second, this must be possible.

While some economists might dissent, nearly all would agree that fiscal policy could be set at a level which would achieve the required level of national savings. It is of course possible to argue for what is known as "Ricardian equivalence". Households may adjust their savings to offset the improvement in the budget balance. Most studies that I have encountered suggest that this happens to some extent, but not sufficiently to make a target for national savings an unachievable target for fiscal policy.

Interim Conclusion.

To summarise my argument so far:
(i) We have a large gap between the wish that the relative incomes of the elderly will not fall and the rate of national savings needed to make the achievement of that wish practicable.
(ii) This gap could be filled if and only if fiscal policy is subordinated to achieving it.

Prospects.

It is possible, but not very easy, to be an optimist about the prospects for the elderly income problem being solved, other than by accident.

The debate has started badly, due to the continuing confusion between household and national savings. Discussion so far has concentrated on inessentials, such as whether savings should be compulsory and whether the state pension should be earnings or inflation related. This reduces discussion to the level of what promises should be made without discussing whether they can be met; in short, a discussion of ends while ignoring means. But this may be an example of a problem being an opportunity and one that is being seized by our hosts today. I hope that the debate will now improve and that this discussion will contribute.

The second reason for caution is the need to reform fiscal policy. To do this, the faults of the present targets have to be accepted. It seems almost impossible for politicians to admit error, but many manage to change direction without seeming to do so. This is, however, easier for some than for others and our current Chancellor does not seem to be well endowed with this particular skill.

The perception of fiscal inflexibility is also, I think, inhibiting the debate. If the Pension Commission believe that a discussion of the fundamental issue is taboo on political grounds, then the chances of raising the level of the debate will remain low.

We Might Muddle Through.

Despite the problems, there is a reasonable chance that we might muddle through. In saying this I am perhaps in danger of being the economists' equivalent of Oliver Edwards, the sage, who is recorded in Boswell's Life of Johnson as remarking that he 'wanted to be a philosopher, but cheerfulness kept breaking in'.

My hope is that we could witness a rise in household savings without a compensating deterioration in the savings of business and government.

Household savings have fallen to an extremely low level. Because the figures are presented differently - gross for the UK and net for the US, it seems seldom appreciated that the level in both countries is almost the same and virtually zero in both on a net basis. In both cases the driving force seems to have been the rise in asset values, particularly in housing. As we have seen already in the UK, a stabilization of house prices rather than an outright fall may be all that is needed to cause household savings to rise.

If, in addition to this, pension savings are encouraged by some other means, the level of household savings could easily rise by, say, five percentage points of disposable income or three percentage points of GDP.

The impact of this on national savings will depend on the response of corporations and government. Profits are high and a rise in household savings will, ceteris paribus, cause them to fall. Things are not, however, likely to be fully equal. For one thing, the impact of rising household savings will be heavily felt in the government sector, since consumption is more heavily taxed than savings.

There is a reasonable chance therefore that the present fiscal rules, which are highly unsuitable for an economy with a low household savings rate, might help ensure that a rise in the household savings rate, were it to occur, was not fully offset by deteriorating savings in the government sector and that the overall impact would be to achieve a better level of savings at the national level.

Problems of Adjustment.

I should perhaps discard my Oliver Edwards mood by noting the very considerable problems of adjustment that we are likely to encounter in a move to a higher savings environment.

If savings are going to rise, this must be accompanied with either a rise in domestic investment, or a fall in our current account deficit.

If intentions to save rise in advance of these offsetting changes, then a rise in national savings will be thwarted by a weak economy. An easy adjustment is possible, but it is unlikely in almost any circumstances. It seems particularly unlikely today when sterling is, by historic standards, expensive and when external demand is far from robust.

The World Problem.

The lack of a robust world environment is, I believe, a reflection of the fact that the world faces a problem which is similar and often worse than that of the UK.

Dr Ben Bernanke's view that the world suffers from an ex-ante savings surplus has been generally accepted. Indeed it is almost a tautology, in that the world economy is far from robust despite the low level of real interest rates and the high level of budget deficits. The importance of the point seems, however, to me to be the persistence rather than the existence of this apparent surplus. This suggests that the problem is structural rather than cyclical.

Since the problem of ageing is a worldwide rather than a peculiarly UK matter, it seems reasonable to see demographic change as the key to this ex-ante savings surplus. If the solution to the demographic problem is to increase savings, as I have argued that it is, then one part of this is relatively easy. The large budget deficits and low real interest rates, which have been used to prevent the ex-ante savings from depressing demand, need to be ended. In their place, however, some alternative source of demand is needed to prevent recession thwarting the savings in a more unpleasant way than the fiscal and monetary policies which have achieved this so far.

On a world view, the only viable way forward that I can see is for the cost of capital to be reduced, so that investment is boosted rather than savings thwarted. This cannot be achieved by low real interest rates, which serve to reduce savings rather than boost investment. A possible answer is a major reduction in corporation tax.

Reverting once again to my Oliver Edwards mood, I see a combination of international competition and financial engineering as making the collection of corporation tax increasingly difficult. It would be encouraging to think that governments will increasingly recognize this, both with regard to the fact and to the benefits that it should bring.

Andrew Smithers
Smithers & Co.

Smithers & Co. Ltd. provides advice on international asset allocation to about 100 clients based mainly in Boston, London, New York and Tokyo. Our work is based on the fundamental belief that no one's judgement is better than their information. We believe that our clients' decisions will be helped if we can provide them with important information that is not otherwise available to them. We therefore concentrate on research which aims either to tackle issues in greater detail and thoroughness than is otherwise available or to tackle issues of importance which seem to have been generally overlooked. Examples of the former include our work on stock market valuation, the profit distortions arising from the use of employee stock options and the underlying secular problems of Japan's economy. Examples of research into areas which have otherwise been largely overlooked include our work on the Japanese life insurance industry.

Our approach to research is also different. The standard approach bases market projections on economic forecasts of major economic aggregates, such as GDP and inflation. Stock market, bond and currency forecasts are then derived from the way these estimates differ from the consensus. We consider this approach to be flawed in two ways. It places excessive reliance on the ability of any particular analyst to produce forecasts which are consistently better than average. It also ignores the evidence that stock markets tend to lead economies, rather than the other way around. In contrast, we put greater emphasis on "information arbitrage", in which we include identifying factors which have been overlooked, drawing on data and academic research which have not yet been exploited and pointing to inconsistencies in the implicit forecasts of different markets.

Andrew Smithers, founder of Smithers & Co., is also columnist for London's Evening Standard and the Tokyo Nikkei Kinnyu Shimbon's Market Eye, and is regularly quoted in the New York Times, Barron's, Forbes, The Economist, The Independent, and the Financial Times.

Copyright © 2002-2007 Andrew Smithers

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