Sunday, March 22, 2009


The issue of pension reform is definitely the most challenging macroeconomic issue in the time to come. Faced with unfavorable demographic situation, economic policymakers in Western countries will need to reconsider the structure of the pension system to ensure the long-term sustainability of pension systems and overall macroeconomic stability as well. Negative demographic trends, namely a decreasing labor supply relative to increasing retirement rates as post-WW2 baby-boom generations retire and the burden of the welfare state is beared by the existing labor supply thru higher tax burden unless the reforms are launched.

Jose Pinera predicted (link) that Europe's aging population and the unsustainability of pension systems in the Euroarea could distort the functioning of optimum currency area and, consequently, launch a series of instability issue in the euroarea due to the inability of fiscal policies to cope with the exponentially growing net financial liabilities to the retirement system. Ageing population is, of course, more pronounce in the euroarea and Japan compared to the United States or Canada. In G7, assuming ceteris paribus, dependency ratio is expected to move from 40 percent to 70 percent by 2050.

The evidence from the OECD predicts that by 2050, Spain and Italy will face the highest dependency ratios. In Sweden, where private retirement accounts have been introduced (link) as a long-range supplementary to PAYG system back in 2000 (link), the trend of the ratio of population aged 65 and over is expected to reverse between 2030 and 2040. The United States is the only advanced country where the share of population aged 65 and over is not expected exceed 40 percent of the overall population (link).

Recently, Martin Neil Baily and Jacob Funk Kirkegaard of the Peterson Institute wrote a book entitled US Pension Reform: Lessons from Other Countries (link). The authors examined the prospects for the reform of the pension system in the United States considering the evidence from abroad. They showed that southern (Spain, Italy, Greece, Portugal) and continental (France, Germany, Belgium, Austria, Hungary, Slovenia) European countries are in the dead-end scenario of weak total assets of the pension system, unsound government finances. Although Austria, Spain and Belgium had a surplus structural fiscal balance in 2006, these countries are still unfamous for high corporate and personal income tax burden which has, by all empirical proportions, a negative overall effect on labor supply as working time is substituted for leisure activities, while as those of you who studied introductory micro and macro, productivity is the key to higher standards of living.

There is a three-step approach that European welfare states must face sooner or later if these countries want to avoid a continuous macroeconomic crisis whose effect is similar to oil supply shocks in 1970s. First, pension systems should be privatized by the introduction of private retirement accounts and PAYG net financial obligations should diminish gradually either in the framework of fiscal policy rule or in terms of partial lump-sum in the intragenerational transfer. Second, the transition to private retirement accounts must ensure the combination of risk-management approach to portfolio investment and returns managed by private pension funds. Sound and smart regulation should not be avoided such as the avoidance of investment into toxic assets backed by subprime mortgages where a decreasing interest rate has virtually inflated assets prices and propelled a the burst of the bubble that spurred the financial crisis in 2008/2009.

However, lessons from financial crisis and financial innovation will probably peer the question whether pension funds shall benefit from investing in asset-backed securities. Traditionally, pension funds diverse the portfolio structure by hedging or diversification into a stable and predictable rates of return with low beta coefficient on most of securities as pension fund managers aim to reduce the variability of return rates as risk fluctuates except for in optional accounts. And third, European countries should immediately deregulate its rigid and inflexible labor markets and also strongly decrease marginal and average tax rate on personal and corporate income and should nevertheless immediately raise the retirement age in the effort to stimulate labor supply and avoid early retirement. The combination of high tax burden, early retirement age and inflexible labor markets is a vicious circle where stagnation, ageing time bomb and macroeconomic crisis are the main consequence of delaying pension reforms into the future while such reforms never really happen.

Thursday, March 19, 2009


WSJ reports that French president is under pressure of labor unions to raise taxes on the wealthy as an act of solidarity (link). Meanwhile, France's economy deteriorated significantly in the light of recession and turmoil of the financial crisis. The economy is expected to decline by 1,9 percent in 2009 on the annual basis. The forecasting prospect for French economy in 2010 is also a little grimmy. The IMF expects 0.7 percent economic growth in 2010 (link). The stagnation of France has been diagnosed as a consequence of high tax burden, inefficient and oversized public sector and rigid labor markets which hinder productivity growth and further deteriorate the already unsustainable social security and pay-as-you-go pension system when net financial liabilities increase exponentially in the share of the GDP. The OECD has shown an interesting comparison (link) of tax burden on labor supply in OECD countires. France, Belgium, Hungary and Germany are in the top ladder of tax burden on labor supply, where tax burden on average workers is very close or above 50 percent of labor cost while the OECD average is slightly below 40 percent.


The Fed declared that it would buy as much as $300 billion of long-term treasury securities and even more in mortgage-backed securities. While the Fed has already targeted federal funds rate to 0,25 percent, the prices on US Treasury debt have soared, pushing the yield on 10-year notes from 3 percent to 2.53 percent. The WSJ reports:

The Fed will buy as much as $300 billion in long-term Treasurys in the next six months. It will increase the ceiling on purchases of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac to $1.25 trillion, up from $500 billion. The Fed also is doubling potential purchases of their debt, to $200 billion (link).

Zero-ground interest rate is a serious concern regarding the long-term conduct of the monetary policy. While the major central banks have already plummeted into a liquidity trap, it is surprising that stock markets and macro data on employment and output are not responding to the proposed policy measures. If the Fed is likely to buy more long-term Treasury securities in the following months, an unparalleled increase in government debt may occur which could deteriorate the state of macroeconomic stability which is unlikely to be mitigated by neither fiscal nor monetary policy. If the Fed really aims to tackle the economic recovery, then it should set time-consistent policy rule, declaring a stop to further policy rates with a clear and indisputable statement in mind.

Thursday, March 12, 2009

Tuesday, March 10, 2009


Here is a link to Christina Romer's speech about the lessons from the Great Depression and the economic recovery of 2009, presented yesterday at the Brookings Institution.

Monday, March 09, 2009


A new study by IMF (link) suggests a framework for fiscal policy during recessionary periods. IMF admits that discretionary fiscal policy could further deteriorate economic recovery, increasing budget deficits and public debt which already reached new heights in G20 countries (link). It also suggets that vulnerabilities from financial markets should be addressed in preventing economic downturns. Agreeably, IMF does not suggest an introduction of large-scale entitlement programs which are politically almost impossible to reverse as well as an increase in public sector bill that could downsize productivity performance and exert a growing pressure on cost inflation. The study also concludes that industry-specific subsidies are harmful and could escalate protectionism. The study, however, does not recommend lower corporate tax rate, saying that tax reduction is likely to be ineffective leading to tax fraud. Numerous empirical studies have shown that high corporate tax rate is the primary reason for tax evasion, pushing private sector to move to jurisdictions with lower tax rates. And second, it would be suspicious to claim that corporate tax cut is ineffective because business profits are low. It is true that corporate tax reductions lead to higher tax multiplier and exert strong upward pressure during expansionary period, but that does not mean that corporate tax cut is ineffective during recessions. In fact, cutting taxes during recession eases the economic downturn as well as the pace of the recovery.

Thursday, March 05, 2009


Back in 2005, Vaclav Klaus delivered a great speech (link) on why there is a huge and remarkable inclination of intellectuals towards the ideas of socialism.

"As we see both in Europe and in America, the intellectuals love such a system. It gives them money and an easy life. It gives them an opportunity to be influential and to be heard. The Western world is still affluent enough to be able to support and finance many of their unpractical and directly unpurposeful activities. It can afford the luxury of employing herds of intellectuals to use “poetry” for praising the existing system, for selling the concept of positive rights, for advocating constructivist human designs (instead of spontaneous human action), for promoting other values than freedom and liberty."