Positive Real Interest Rate

The main observation is a rather surprising one. Once we introduce a positive real interest rate, the Social Security system makes people worse off. Remember that we concluded earlier that the system had no effect on the total resources in the hands of the household. Households are taxed when they are young, though, and get that money returned to them when they are old. With positive real interest rates, they would strictly prefer the money when they were young. This result seems odd. A Social Security system allows the government, in effect, to borrow from the future, taxing younger generations to pay older generations. So how does it end up making people worse off? A key part of the answer is that, when the system was first introduced, the first generation of old people obtained benefits without having to make contributions. In the past, therefore, the introduction of the Social Security system did make one group of people better off. Economic Growth As we know, most economies grow over time. We neglected this in our analysis. Economic growth has two implications for Social Security: one unimportant and one more significant. First, economic growth is another reason why individuals’ incomes increase over the course of their lifetimes. We have already observed that this does not change the fundamental idea of lifetime consumption smoothing: you still add lifetime income in both working and nonworking years and then divide by the number of years of life to find the optimal level of consumption. More interestingly, economic growth also means that Social Security payments increase over time. As the income of workers increases because of economic growth, so too does the amount of tax collected by the government. If the Social Security system is in balance at all times, Social Security payments must also increase. Thus when workers are retired, they continue to enjoy the benefits of economic growth. (In fact, if the growth rate of the economy happened to be the same as the real interest rate, the effect of positive economic growth would exactly offset the negative effect of real interest rates.) Normally, the effect of economic growth partially offsets the negative effect of positive real interest rates. Access to Credit Markets In our setting, individuals were able to save without difficulty at the market real interest rate (which was zero in our basic formulation). In the jargon of economics, individuals have good access to credit markets. Yet many individuals in reality have a limited ability to borrow and lend. [1] There is ample evidence that many people do not actively participate in stock markets: they do not hold mutual funds or shares of individual companies’ stocks. Such individuals typically save by putting money in a bank, and the interest they earn is relatively low. In particular, it is lower than the interest that the Social Security Trust Fund can earn. Social Security in effect allows the government to do some saving on behalf of individuals at a better interest rate than they themselves can earn. Thus individuals who do not have good access to capital markets can be made better off by access to a Social Security system. This is in some ways the exact opposite of the argument for privatization. Supporters of privatization argue that if individuals can make their own investment decisions, they can earn a better interest rate than is provided by Social Security.