Economics 101: Old age also means accepting a fall in living standards
How should governments organise pensions?
Pensions seem straightforward: governments simply have to devise a system that ensures that people save enough of their income. It is basically that simple when you are dealing with an individual, but when you are organising something at the population level, it is more complicated.
At any point in time, the population is composed of young and old. For the sake of simplicity, imagine old people cannot produce goods due to physical limitations. How, then, will old people get the goods that they need to live? They have two options.
The first is that they can consume goods that they earned when they were young, and “stored” (saved), such as their house or TV. That works fine for durable commodities, but for things like bananas, haircuts or taxi rides, long-term storage is not an option.
The second option is convincing a young person to surrender some of the goods that the young person earns from working. Some will do it voluntarily out of altruism, such as your children, but that might not be enough, which means that the young “donor” has to get something in return.
The solution is for an organisation that lives longer than the young and old, such as a bank or the government, to compensate the young person for surrendering some of their earnings by promising to give them goods when the young person becomes old and unable to work. This is how a government “pay-as-you-go” pension system works: the national insurance contributions of people who are currently working are used to pay the pensions of people who are currently retired.
This system works fine if birth rates are either stable or rising. It breaks down if birth rates are falling, which is exactly what is happening in almost all rich countries at present. Under these circumstances, when the current young generation gets old, they will represent a larger percentage of the population than in the past, meaning that the production of the young has to be spread more thinly across society.
That means that someone – young, old, or both – will have to suffer declining living standards. Humans intensely, almost irrationally, dislike falling living standards, and they usually cause significant societal problems.
The problem is exacerbated by the fact that old people are living longer, and their consumption needs are growing, especially costly medical treatments.
What is the solution to this quandary? Actually, there is no internal solution – people just have to get used to falling living standards, which hasn’t really occurred for 200 years. Note that private pensions are a red herring: if you buy stocks when you are young, then when you are old the real value of your stocks will decline significantly when you try to liquidate them to cover your living costs, because there is no way around the fact that there are not enough goods being produced; there are not enough young people and too many old people.
Individual countries can get around this by allowing for a large number of young people to immigrate, but that is politically untenable in most places. Raising retirement ages helps, but eventually people are physically unable to work, but still consume, meaning that the problem comes back.
Perhaps you are wondering if there is some catch, as if things were really as simple and negative as I have described, more people would be talking about it. Well, it’s a bit like global warming: politicians certainly don’t want to bring attention to the problem since humans tend to shoot the messenger. We are not yet staring down the abyss, and so it’s easier to just bury our heads in the sand.
Personally, I have already accepted the fact that my living standard will be significantly lower in the future, and I recommend that you do the same.
Omar Al Ubaydli is the programme director for international and geopolitical studies at the Bahrain Center for Strategic, International and Energy Studies, and an affiliated associate professor of economics at George Mason University in the US.
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Updated: October 22, 2016 04:00 AM