Wednesday, July 11, 2007


Faced with long-term age-dependency crisis and with the falling labor supply, Finnish policymakers recently decided to endorse a substantial reform of the pension system which, in Finland, consists of two main parts - earnings-based system and the national pension system. The contribution rate for social security currently stands at 21,5 percent for the employers and 12,4 percent for employees. As we can see from the picture below, in Finland, age dependency will dramatically increase over the next 50 years, with age ratio getting closer to 0,5.

Lassila and Valkonen (2006) thoroughly examined the effects of the recent pension reform in Finland. They applied Auerbach-Kotlikoff's FOG model - a numerical overlapping generations model with perfect foresight, dividing the sectors into five different snaps (households, enterprises, government, pension fund and foreign sector) and predicting the rational behavior of households and firms whose decision concept is based on forward-looking decision making. How much macroeconomic implications will the endorsement of the reform have on macroeconomic variables, namely output, investment and inflation? A the predicting behavior of the households is not myopic, as Keynesian economic theory has predicted, the households adjust their preferences for leisure, labor supply and consumption, nevertheless taking the effects of inflation forecast into their consumption function and thus carefully choosing the optimal allocation of the resources which they offer on labor market.

In Finnish case, as well as in any other case of the reform, adjustment costs beared by the individual agents cannot simply be neglected. For example, the increase in the contribution rate could rampantly change the consumption preference and it can also seriously affect the unsustainability of the generous public schemes, driving the overall pension system to breakdown and thus fueling the bubble of the fiscal crisis. Pension crisis can also shuttle the investment as a part of the firm's foremost decisions. Investment behavior could be much less rigorous if an unusually high contribution rate to pension scheme could deteriorate both, the capital formation and stocks of capital, further bubbling the baloon of firm's decision over allocation of the resources, causing shareholder's stock price blows and discounting the sums of dividends.

Contemporary economic theory has shown several times how utility-maximising agents decrease the utility-type consumption in case if government increases its share in providing utility services. Pension crisis goes further as it creates a vastly generous scheme which accelerates the dependency crisis as well as the spiral of out-blowing net financial liabilities emerging from the mistakenly undertaken welfare approach which, in case of a sample public pension scheme, does actually not take the multiplied decision-making and cost-benefit analysis effect into account. In that case, the macroeconomic consequences could stretch beyond the very possible imagination, causing inflation pressures and fiscal crisis, thus further hampering the stability of the public finance.

As we can see, Finnish pension reform has rewarded longer working longevity, shifted from rigid to more flexible accural rates, and discounted the benefits celings of early retirement which is a good sign of ensuring the long-term risk over which demographic implications reveal the true cause for the pension reform. It is a very positive sign, that the reform simplified private pension accounts and made them more attractive to invest in line with the increasing overall labor supply dynamics. Also, the reform postponed early retirement and curbed the contribution rate increase pressure by introducing a new model insurance rights, which reward the long stay in the workplace. Empirically, there are many arguments showing the real benefits of the pension reform on shining output performance. But there is some doubt about the contribution rate which is forecasted to increase slightly over periods, resulted from still much generous public retirement schemes. It is also glad to see how a typical Scandinavian welfare state faced the problems of ageing population and tackled them immediately, an endorsement from which Finns will definitely benefit in the future.

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