With Donald Trump voted in as the 45^th US President, the world economy has witnessed another sobering reminder of the rise of populism, inward-looking politics and a sweeping anti-establishment wave, having barely recovered from the last with Britain’s vote to leave the EU. Initial market turmoil from Trump’s surprise victory last Thursday has reversed, as fiscal stimulus takes centre stage on Trump’s economic agenda, but does the Trump plan have what it takes to kick-start the US economy?

“We have a great economic plan, we will double our growth and have the strongest economy anywhere in the world” was the promise made by US President –elect Donald Trump; to “make America great again”. Having won the confidence of millions of Americans, against a backdrop of stagnant productivity, weak wage growth and rising inequality, Trump’s “great economic plan” has a lot to deliver.

With the US economy having grown a little over 2 per cent on average over the last six years, and forecast to grow slightly under for the next six[i], doubling of current growth would require something quite extraordinary. Even compared to pre-crisis growth of 3 per cent per year in the decade preceding the financial crisis, this target looks ambitious.  If achieved, however, the US economy could close over half of the shortfall compared to its pre-crisis trend by 2021, as in figure 1.

The challenge then becomes finding new drivers of productivity growth to boost economic activity, and lifting lacklustre demand. Since the financial crisis, this has proven difficult, despite ultra-loose monetary policy. Moreover, growth in potential output has failed to materialise during the recovery, as evident in the US Congressional Budget Office’s consecutive downwards revisions to US potential output since 2008, as in figure 2. Figure 2 has come to be closely associated with an idea that the weak recovery may have at its heart a more structural rather than cyclical cause, also known as Secular Stagnation.

The Secular Stagnation Hypothesis

The term secular stagnation was initially coined by Alvin Hanson in 1938, in the aftermath of the Great Depression, questioning whether demand would be sufficient to support future economic growth.  After over 70 years, former US Treasury Secretary Larry Summers revived this debate, after observing the weak economic recovery in advanced economies despite historically low interest rates. Summers suggests that the real interest rate, required to keep full employment and balance investment and savings, may actually be negative.

This may be due to a chronic shortfall of demand from a lack of productive investment opportunities and a build-up of savings, driven by demographic factors such as ageing populations or a fall in the relative price of capital. Moreover, with advanced economies experiencing low levels of inflation, boosting demand by reducing real interest rates becomes more difficult with monetary policy becoming ineffective at the zero lower bound, shifting the onus to fiscal and structural policies to support economic growth

The secular stagnation hypothesis finds some support in the evidence, with the real interest rate observed to be declining since the early 2000’s[ii]. However, former US Federal Reserve Chairman Ben Bernanke interprets this as evidence of a temporary or cyclical “global savings glut”[iii]. Considering the open economy, he suggests excess savings have built up due to large current account surpluses held by oil producing and emerging economies. As Bernanke emphasises the root of the problem matters for the policy prescription: a structural demand deficit (under Secular Stagnation) may require a fiscal expansion, while a temporary excess or imbalance of savings would be best addressed through increasing mobility of international capital flows.

 

Weak growth – a global problem

The challenges of weak growth and productivity are not solely faced by the US. Similar trends have been observed across advanced economies such as the Euro Area and Japan, with potential output consistently disappointing to the downside[iv]. The IMF’s World Economic Outlook published last month revised down again forecasts for growth in advanced economies, to 1.6 per cent in 2016 and 1.8 per cent in 2017, down by -0.5 and -0.3 percentage points from start of this year alone. Furthermore, the IMF warned that “persistent stagnation in advanced economies could further fuel anti-trade sentiment, stifling growth”.

 

The “great economic plan”….

As it slowly emerges and gains coherence, Trump’s economic plan is a cocktail of fiscal expansion and trade protectionism.  In theory, a package of tax cuts and deregulation should incentivise more investment by lowering the marginal tax rate on investment returns. This could provide a pivotal boost to the US economy – provided it doesn’t break the bank first. The Tax Policy Centre estimates a sizeable increase in national debt, by almost 80 per cent [recently revised down to 50 per cent] of GDP over the next 20 years[v], with benefits most likely only for the highest income earners.

Moreover, notable economists including Larry Summers and Adam Posen have criticised the package for being “ill-designed”[vi], providing tax cuts which are likely to be “low-multiplier rather than high-multiplier and budget-busting rather than responsible”[vii]. Worse still, if these tax cuts are funded through cuts in more productive spending such as research & development or education, they could actually undermine growth.

Trump’s protectionist stance on trade would also drag on growth with severe implications for the global economy. Campaign promises of 45 and 35 percent import tariffs from China and Mexico could result in a trade war, and end up costing the US economy 4.8 million[viii] jobs, while tougher foreign investment rules could worsen the “global savings glut”. As the election campaign did not fail to shock and surprise, so developments across these areas continue to present both upside and downside risks, with some forecasters even predicting a recession by the start of 2018[ix].

 

Don’t forget the Fed

US equity markets, which once dived at the prospect of Hillary Clinton losing, have since rallied over the prospect of Trump’s fiscal expansion plans, while government yields continue rising with expectations of inflationary pressures to follow. With the US economy already close to the 2% inflation target and near full employment, there is a strong case for interest rate hikes starting in December. But as the Federal Reserve Chair Janet Yellen warned, a series of aggressive rate hikes could stall growth, pushing Trump’s doubling of growth target even further out of reach. Much of the success of any fiscal expansion will depend on multipliers and the associated monetary policy response (to be explored in an upcoming post), and as Yellen emphasised a great deal of uncertainty still surrounds the proposed economic policies. For now at least, ‘Trumponomics’ seems unlikely to be the solution to our secular stagnation problems.

 

References

[i] IMF World Economic Outlook, “Subdued Demand: Symptoms and Remedies”, October 2016

[ii] King, M., & Low, D., “Measuring the World Real Interest Rate”, NBER Working Paper w19887

[iii] Bernanke, B., “Why are interest rates so low, part 3: The Global Savings Glut”, Brookings, April 2015

[iv] Summers, L., “Reflections on the new ‘Secular Stagnation hypothesis”, VOXEU,  30 October 2014

[v] Nunns., J et al., “Analysis of Donald Trump’s Tax Plan”, Tax Policy Centre Research Report, December 2015

[vi] Gurdus, E., “Larry Summers: Trump’s economic plan is ‘ill-designed’ and harmful”, CNBC,  16^th November 2016

[vii] Acton, G., “‘Trumponomics’ is unfunded, open-ended and kind of ridiculous, economist Adam Posen says”, CNBC, 16^th November 2016

[viii]  Nolan, M., et al. “Assessing Trade Agendas in the US Presidential Campaign”, Peterson Institute for International Economics, September 2016

[ix] Zandi et al, “The Macroeconomic Consequences of Mr. Trump’s Economic Policies”, Moody’s Analytics, June 2016

The Political Future of the European Union

By Giacomo Ponzetto

The next session moved on to the political economy of the EU. Professor Ponzetto started his presentation by sketching the classical theory of fiscal federalism that gives insights on both the current state of the EU and its future.

This theory boils down to the trade off between the benefits of policy coordination and the costs of policy uniformity: is there too much (for example many economists agree that the agricultural pact went too far; the same goes for monetary union with less consensus) or too little (since there is a monetary union, fiscal union needs to be achieved) coordination in the current European framework? The cost-benefit analysis becomes even trickier when the size of the union kicks in: with whom should we coordinate? Is the European Union overstretched, should it continue to expand to new countries? Over time a neoliberal consensus has emerged, embodied by the research work of Alberto Alesina (1999, 2005), pointing at a union that is too small and homogenous. This union has also seized the control of too many policies: this research tells us that any decision maker will take control of a policy whenever he has the possibility, whereas some policies would be best kept off limits as voters do not necessarily agree to delegate them. Furthermore, no matter it does too much or too little, the European Union is doing it wrong according to this neoliberal consensus: the single market is too little enforced, and so are the public goods (failure of coordination of foreign policy, defense); on the other side, it does way too much redistribution and local public services.

Professor Ponzetto highlighted two different scenarios for the future of Europe in the context of global economic integration. In the continuity of Brexit, the first possible outcome is that globalization renders the EU irrelevant, up to its dissolution, since its main realization, the single market, loses its competitive advantage with rising global trade. Here members no longer need to bear the cost of uniformity. On the contrary, it could also strengthen the European Union thanks to the very same single market. It could be the appropriate tool to take advantage of rising trade opportunities and common economic regulation that fosters economic integration as noted by Gancia, Ponzetto and Ventura (2016). In any case, Brexit may offer a natural experiment to check which of these scenarios is correct. Looking at qualitative data published by the Pew Research Center before the vote offers a mixed picture: the short term agreement on an “ever closer” union looks is a stretch, while it could change in the long term as younger adults are more likely to favour the EU.

 

Source: Euroskepticism Beyond Brexit, Pew Research Center, June 2016

The presentation then turned to the topic that really complicates European Union’s relation to voters: shared responsibility and political accountability. In practice, the EU has exclusive control on a very limited number of policies. Though a flexible combination of European and national responsibility seemed beneficial (Alesina, Angeloni and Etro, 2005), it also generated opacity and loss of accountability (Joanis, 2014): who is responsible for policy outcomes? This question enabled politicians to blame the European Union and holding it responsible for any policy failure. As such, a better enforcement of accountability through clear delegated monitoring would be welcome. Boffa, Piolatto and Ponzetto (2016) found that differences in government accountability (for example Germany versus Italy) make the union more desirable by helping countries converge to the best practices. Political economy also tells us that a fiscal union does not seem very likely to happen for two reasons highlighted by Persson and Tabellini (1996): moral hazard in local policy (higher risk taking); and the fact that risk sharing entails redistribution (not in theory but always in practice). It also provides some other insights on the hostility to immigration through three factors: labour-market competition (see Professor di Giovanni’s presentation), pressure on the welfare state and xenophobia.

Gazing into his crystal ball, Professor Ponzetto concluded his presentation by reminding us that the EU remains very cautious and does not aim at grand reform. On the positive side, the single market will probably go forward and continue to deepen, in particular for the European financial markets. On the negative side, he remarks that the current (and old) inefficiencies will probably continue for quite some time. Also, barring a significant shift in German politics, the fiscal doctrine is not likely to move from austerity to pro-competitive reforms.

 

References:

Alberto Alesina, Ignazio Angeloni, Federico Etro, 2005. “International Unions”, American Economic Review

Federico Boffa, Amedeo Piolatto & Giacomo A.M. Ponzetto, 2016. “Political Centralization and Government Accountability” Quarterly Journal of Economics

Marcelin Joanis, 2014. Shared Accountability and Partial Decentralization in Local Public Good Provision. Journal of Development Economics

Gino Gancia, Giacomo Ponzetto, Jaume Ventura, 2016. “Globalization and Political Structure”, NBER Working Paper No. 22046

Torsten Persson, Guido Tabellini, 1996. “Federal Fiscal Constitutions: Risk Sharing and Redistribution”, Journal of Political Economy

Bruce Stokes, Euroskepticism Beyond Brexit, Pew Research Center, June 7, 2016

Migration in the EU and its economic impacts

By Julian di Giovani

Professor di Giovani continued the roundtable with a presentation on the theme of migration in the EU. He first articulated it around a thorough analysis of the current situation and the data. Even if inflows massively increased in 2015 due to the refugee crisis, migration in the EU is not not new and deals with various inflows coming from outside and inside the EU. Looking at historical data, migration to Europe has been a steady process since WWII and notably accelerated in 2006 after the significant extension of the European Union to ten countries, mostly in Eastern Europe.  Contrary to what is usually expected, the proportion of foreigners in 2014 was similar in the US and in the largest European countries.

Research has been very active in breaking down and understanding the net economic impact of immigration, with an extensive literature on underlying economic variables. The first results from Borjas (1995) highlighted limited gains (to the tune of 0.1% of GDP) and even negative aggregate gains. Borjas found that overall gains were lower than net fiscal costs implying a transfer of wealth from nationals to immigrants. However, Borjas already added place for positive effects when the level of skills of immigrants was taken into account. Recent research has shown larger gains of immigration: Klein and Ventura (2007) through labour reallocation extension in a growth model; di Giovanni, Levchenko and Ortega (2015) in multicountry model that focuses on increased varieties and remittances. Another line of research summarized by Clemens (2011), noted that globalization was most successful in terms of economic gains with the mobility of the labour factor rather than that of capital and goods.

Source: “Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?”, Clemens, M., Journal of Economic Perspectives, 2011

Ortega and Peri (2014) also found positive evidence in a cross-country analysis of income per person and predicted openness to migrants, with results driven by Total Factor Productivity due to diversity effects such as differentiated skills in labour force and increased innovation. Labour market outcomes are also addressed in de la Rica, Glitz and Ortega (2015) with the confirmation that migrants are more unemployed and paid less but also that countries are unequal in education level of their migrant populations. The direct question is then the distributional effects of these labour market outcomes for native workers. The first results are mixed: Borjas (2003) finds that immigration is responsible for large drop in unskilled wages in the US while Ottaviano and Peri (2012) establish the opposite in a model that allows imperfect substitution between immigrants and nationals with equal education and experience. Looking at the firm-level data in Germany, Dustmann and Glitz (2015) show that changes in the skill mix of local labor supply are mostly absorbed by adjustments within firms with changes in relative factor intensities as well as firms entering and exiting the market. Finally, net fiscal effects remain hard to estimate. Contrary to Borjas (1995), Dustmann and Frattini (2014) get a positive and substantial effect when exploiting micro data for the UK over 1995-2001.

Going forward, Professor di Giovanni insisted that migration is indeed a blessing for the European Union’s ageing population and can also facilitate the increase of female participation in the labour market. Innovative policy is of course needed but some solutions already exist, such as the EU Blue Card scheme for high-skills workers, and should be more developed to get results in the short run. But this also requires both institutional and social rigidities to be tackled as well as more resources: an appropriate policy reaction should go far beyond the migration issue only, which cannot be taken as an isolated issue.

References:

George J. Borjas, 1995. “The Economic Benefits from Immigration,” Journal of Economic Perspectives

George J. Borjas, 2003. “The Labor Demand Curve is Downward Sloping: Reexamining the Impact of Immigration on the Labor Market”, Quarterly of Journal Economics

Paul Klein, Gustavo J. Ventura, 2007. “TFP Differences and the Aggregate Effects of Labor Mobility in the Long Run” The B.E. Journal of Macroeconomics

Julian Giovanni & Andrei A. Levchenko & Francesc Ortega, 2015. “A Global View Of Cross-Border Migration,” Journal of the European Economic Association

Michael A. Clemens, 2011. “Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?”, Journal of Economic Perspectives

Francesc Ortega, Giovanni Peri, 2014. “Openness and income: The roles of trade and migration”, Journal of International Economics

Gianmarco I. P. Ottaviano & Giovanni Peri, 2012. “Rethinking The Effect of Immigration On Wages,” Journal of the European Economic Association

Christian Dustmann & Albrecht Glitz, 2015. “How Do Industries and Firms Respond to Changes in Local Labor Supply?”, Journal of Labor Economics

Christian Dustmann & Tommaso Frattini, 2014. “The Fiscal Effects of Immigration to the UK”, Economic Journal

A European (dis)Union

“What is going wrong in the European Union these days?” is probably the question that many European voters have been trying to answer in the past few years and all recent events keep pointing at it. First, the recent showdown between Bundesbank President Weidmann and ECB President Draghi on fiscal policy reminded us that even the monetary union, though initiated first to trigger political union, remains a far from smooth cooperation. Second, the theme of (im)migration has been at the very core of the Brexit campaign and added to the overall dissent among European political leaders. This brings us to a last topic of politics at the European level that will be key to deliver solutions.

In such a dense context, the 14^th BGSE Economics Trobada 2016 ended up with a very much welcome roundtable focused on “The Future of Europe” and chaired by Professor Jaume Ventura. To help us understand better these various challenges for the EU and its future, Professor Ventura gathered the affiliated Barcelona GSE professors Fernando Broner, Julian di Giovanni and Giacomo Ponzetto.

Breaking the Bank and Bailing out States: Finance in the EU

By Fernando Broner

European Financial Markets

Professor Broner first presented the financial structure of European capital markets, in opposition to that of the United States. Notably, he highlighted that while equity markets play a greater role than banking sector assets in the US, the relation is more than inverted in the EU where banking sector assets are almost six times the size of equity assets.

Equity markets are regulated by the European Securities and Markets Authority (ESMA), founded only recently in 2011. As pointed by Professor Broner, this young regulator still suffers from weak coordination which restrains its action and thus the extension and deepening of European equity markets. Similarly, the International Financial Reporting Standards (IFRS), adopted in 2002 to bring a unified framework and hence foster equity markets, has not been fully enforced. On top of these regulatory inefficiencies, two more reasons also weigh on European equity markets: a strong home bias (64% of EU and 61% of Eurozone equity is held domestically) instead of more interconnections between European countries; as well as the fact that banks mostly lend to each other through debt instruments.

Despite European banks having large activities abroad (18% vs 9% in the US), they are smaller and less diversified, in comparison to their American competitors. However, Professor Broner noted that the crisis prevention framework was today better articulated, under the ECB’s Single Supervisory Mechanism and an improved interaction between the European Commission and the European Banking Authority (EBA) at the rule-making level. The picture is less positive though for crisis management due to responsibilities shared at both the national (lender of last resort, deposit insurance) and European level (Single Resolution Mechanism (SRM) and European Stability Mechanism (ESM)).

Sovereign Debt and Bail Out control

Professor Broner then turned to sovereign debt, another highly sensitive topic for the EU. Prior to the global financial crisis, sovereign risk had almost disappeared in the Euro-area as spreads for all countries were trading in the same range. Part of this decline and convergence in spreads could be explained by expectations of “automatic” bail-outs and a higher cost of default, which proved both inefficient and inaccurate. Along the Eurozone debt crises, various packages were set up to address bail-outs: at the beginning the International Monetary Fund was very active along with European countries and progressively took a step back to let the EU new financial institutions (first the European Financial Stability Facility then the ESM) take over and manage the bail-outs packages. Even the ECB has been directly involved with its Security Markets Programme enacted in 2010 to purchase mostly sovereign bonds. Professor Broner highlighted the unclear role of the ESM: it is similar to a bank capitalized by Eurozone members, whose priority is to provide liquidity. However, it remains criticized by some countries as it offers a kind of transfer scheme, notably through its high maturity loans at very low interest rates. Another challenge is the “sovereign-bank embrace” generated by the current institutional setup, with Eurozone banks holding more and more government bonds. This has serious implications as it crowds out lending to the private sector and reinforces banks’ exposure to sovereign risk while reciprocally banks’ exposure affects also government on the fiscal side as the cost of banking crises significantly participated to the sharp increase of public debt ratios of these countries.

Source: Professor Broner’s presentation

Professor Broner concluded his presentation with some recommendations for the future of European finance. First, remaining barriers to international diversification in the equity markets should be removed. Second, banks’ risk sharing should be improved by encouraging more equity exposure as well as consolidation across countries with more regulation of banks’ subsidiaries. Finally, there should some disincentive action against the current sovereign-bank embrace trend with a direct lender of last resort scheme, direct ESM funding for recapitalizing banks and limitations to the sovereign exposure.

On 26 October 2016, Chilean economist Dr. José Gabriel Palma gave a lecture, organised by Institut Barcelona d’Estudis Internacionals (IBEI) – “Why is inequality so unequal in the world? Do Nations just get the Inequality they deserve?” During the lecture, he also presented his recently-published working paper, which re-examines the eponymous Palma Ratio [1].

Forces at work

In an earlier paper, published in 2011 [2], Dr. Palma had already highlighted the two forces pertaining to rising inequality across the world: ‘One is ‘centrifugal’, and leads to an increased diversity in the shares appropriated by the top 10 and bottom 40 per cent. The other is ‘centripetal’, and leads to a growing uniformity in the income-share appropriated by deciles 5 to 9’ (Palma, 2011). Decile 10 refers to the top 10 per cent, and deciles 5 to 9 can be interpreted as the middle-upper class. What this means is that the middle-upper class has been quite successful at protecting their shares, and anybody who genuinely wants to understand inequality within a country should really focus on the income-share of the top 10%. As Clinton’s campaign strategist put it crudely: “It’s the share of the rich, stupid.”

Gini or Palma?

The Gini coefficient, developed by Corrado Gini, is an index measuring income inequality, with 0 implying perfect equality, and 1 meaning perfect inequality. The Gini coefficient has been in use for a long time, but is not without its limitations. Atkinson (1970) [3] pointed out that the ‘Gini coefficient attaches more weight to transfers affecting middle income classes and the standard deviation weights transfers at the lower end more heavily.’ In other words, the Gini index is more sensitive to changes in the middle of the distribution, and less sensitive to changes at the top and bottom. Cobham and Sumner (2013) [4] have also echoed similar sentiments and criticised the use of the Gini index. They have in fact coined the term ‘Palma ratio’, which is ‘the ratio of the top 10% of population’s share of gross national income (GNI), divided by the poorest 40% of the population’s share of GNI’ (Cobham and Sumner, 2013).

Why might the Palma ratio be a more relevant indicator of the extent of income disparity in an economy? Why is there a growing consensus that the use of the Palma ratio is more appropriate in formulating policies that aim at reducing poverty? The answer is obvious – if an economy has a high Palma ratio, policy-makers can immediately focus on measures to narrow the gap between the top 10% and the bottom 40%. In Palma’s own words: ‘… … it measures inequality where inequality exists; it is also simple, intuitive, transparent and particularly useful for policy purposes’ (Palma, 2016). In contrast, the Gini index is likely to engender distortions because it reflects changes in the distribution where the probability of such changes (i.e. in the middle-upper class) is the lowest. This is such an important consideration that, during the lecture at IBEI, Dr. Palma cautioned his audience to ponder about norms versus distortions. Indeed, if we are often fixated on the middle-upper class, whose homogeneity is evident across the world, we might just be turning a blind eye to more serious concerns – the norms, that is, the (widening) gap between the extreme ends of the spectrum. In light of this, an inclusion of the Palma ratio in policy design will lead to desirable outcomes.

Other revelations

It is interesting to note that the Palma index has also revealed certain stylised facts.

Source: Palma, 2016

Using the Palma index, the figure shows how inequality increases in an almost linear fashion quite steadily until about the 100th ranking, the point at which most Latin American countries come into the picture (as indicated by the red circles – with the exception of Uruguay), and where inequality starts increasing exponentially.

Moreover, we also need to reconsider the correlation between education and income distribution. Dr. Palma has noted that most of the diversity in educational attainment (especially in terms of tertiary education) across the world is found in the deciles 5 to 9 group. However, ‘why does one find extraordinary similarity across countries in the shares of national income appropriated by this educationally highly diverse group?’ (Palma, 2016). Chile is a case in point. With a rate of 71% of gross tertiary enrolment, the income share generated by deciles 7 to 9 in the country is about the same as that of the Central African Republic, which has a gross tertiary enrolment at only 3.1% (Palma, 2016). Hence, is it really all about education? Or is it that the positive externalities and effects of education will truly manifest themselves only in certain institutional settings? Ostensibly, more research has to be done to unravel the intricacies of the relationship between income disparity and educational attainment.

“We know very little.”

That was what Dr. Palma emphasised, during the lecture, to a sea of concerned faces amongst the audience. However, that is undoubtedly the right attitude to adopt as we challenge certain mainstream ideas in economics. Apart from being assiduous in the journey of constantly refining our tools of analysis, as demonstrated by the shift from the Gini index to the Palma ratio, we should also make a conscientious effort in reflecting about norms versus distortions. Indeed, from time to time, one must always make a critical assessment of the aspects on which one should focus.

References:

[1] Palma, J. G. (2016) ‘Do Nations just get the Inequality they Deserve? The ‘Palma Ratio’ Re-examined’, Cambridge Working Paper Economics, no. 1627, University of Cambridge.

[2] Palma, J. G. (2011) ‘Homogenous middles vs. heterogeneous tails, and the end of the ‘Inverted-U’: the share of the rich is what it’s all about’, Cambridge Working Paper Economics, no. 1111, University of Cambridge.

[3] Atkinson, A. B. (1970) ‘On the Measurement of Inequality’, Journal of Economic Theory 2. p.244-263.

[4] Cobham, A., and Sumner, A. (2013) ‘Is it all about the tails? The Palma Measure of Income Inequality’, CGD Working Papers, no. 343, Center for Global Development.

Written by: Fernando Fernandez and Mario Giarda

photo credit: Reuters

Some weeks ago, The Economist published an article about the state of the pension system in Chile. The article focused on the discontent that the system has generated since it was implemented back in 1981, under the military dictatorship of Augusto Pinochet.

Since its conception, the current Chilean pension system was built on two values: long-run sustainability and individual responsibility. These characteristics should be the building blocks of any pension system, and we think that most people would agree with them. Nowadays, the discontent comes from the low pensions this system is delivering, and the disproportionately high commission/fees charged by pension managers. In our view, given the current parameters of the system (retirement age, monthly individual contributions, return on funds), pensions would be hardly increased without incurring in higher public costs or higher individual effort. So, any scheme (individual accounts, pay-as-you-go, etc.) would face serious challenges in delivering acceptable pensions.

In what follows, we briefly describe the history of the system and analyze its current state. Then we discuss the main issues of recent debates. We argue that the first policy action is to change the parameters the system is working with. Finally, we discuss that the best pension system should be a mixed system based on two pillars: individual contributions and a solidarity pillar, the former financed with individual accounts and the latter funded by the State. This is exactly the current Chile’s pension system. In this piece, we aim to defend it and propose some policies to enhance its performance given the current state of the Chilean economy. Moreover, this article would be helpful to analyze other pension systems that are being stressed by the same developments taking place in Chile, like most European economies and countries have adopted similar systems like Peru.

 

A brief history of the system

The Chilean pension system was reformed during Augusto Pinochet’s dictatorship (1973-1988). In 1981, the reform meant to go from a pay-as-you-go system to a private individual accounts system. The system was later reformed twice,  in 2002 and 2008, under democracy.

The previous system was composed by institutions called “Cajas de Previsión” (union pension funds and banks), which collected contributions from workers in order to deliver a set of benefits to their affiliates. These Cajas were in charge of providing health services, disability pensions, and retirement pensions. By 1979 the system had 35 Cajas and 150 retirement plans. Cajas were based on workers’ occupations (or industries) so individuals from different occupations were allocated into different Cajas. Benefits were fairly similar within each caja, but there were important differences in pension benefits across Cajas. Not surprisingly, given the heterogeneity between Cajas, the overall system was highly segregated and its was especially bad for low income workers.

The system relied on high contributions from both workers and employers. These contributions ranged from 9.5% to 18.8% of workers’ income and from 7% to 44.4% of workers’ salaries charged to employers. These previous rates were much higher than current figures, even when retirement ages were 60 for women and 65 for men, and life expectancy was lower than today. Thus, the system seemed to be sustainable for itself.

The pension reform of 1981 was part of a broader set of reforms conducted under Pinochet’s dictatorship. It went from the old system to a system based on individual accounts. The new system was mandatory for new workers and voluntary for workers that were already in the pay-as-you-go system[1] (i.e. once you changed, you could not go back). In the new system, contributions were made only by workers. In order to make the system attractive, the contribution rate was reduced to 10% of the labor income. These funds enter into an individual account that is managed by a Pension Fund Administrator (AFP, in Spanish). In the beginning, these AFPs charged a high monthly fee to manage the funds; however, they had fallen from 5% of labor income to only 0.47% in more recent times. Retirement ages remained the same despite improvements in life expectancy, but an early retirement scheme was introduced.

The AFPs can invest in domestic or foreign capital markets. Their investments are highly regulated by type of asset, risk level, or countries. Since 2002, affiliates can choose to invest in up to five different funds with different risk profiles.

In 2008, because of low pension benefits, a state-funded solidarity system was introduced using fiscal revenues. These public funds are used for two purposes: to ensure that pension benefits are higher than or equal to a minimum pension and to provide pension benefits to the elderly who did not contribute enough to the system. Finally, the reform also added a voluntary contribution to the pension fund, complemented by a state-provided subsidy. Hence, the current system is a mixed one based on three pillars: the compulsory contribution pillar, the voluntary contribution pillar, and the solidarity pillar.

 

The current state of the system

The functioning of any pension system is mainly determined by two factors: how the labor market works and the demographic structure.

The first factor is the Chilean labor market, which is characterized by low participation rates, especially among women, the young, and the elderly (above 60 years old). These low rates are concentrated among unskilled workers who are more likely to earn both lower and more volatile incomes. According to CASEN 2013[2], labor force participation was 71% for men and 48% for women. Moreover, only 53.3% of employed men held job contracts and this figure is 29.1% for women. Low labor market participation means lower pension benefits, regardless of the system (pay-as-you-go or individual accounts).

Another feature of the Chilean labor market is the low proportion of workers that contributes to the pension system at any time. Only workers with a formal contract contribute to the pension system. One third of the population hold such contracts. This low proportion implies that, for a given worker, the average time of contributing to the system is 22 years for men and for 15 women.  Evidently, this period is not long enough because pension benefits are supposed to finance retirees’ consumption for 19 years in men and 29 years in women, according to current life expectancy figures. With these figures in mind, it is easy to see that in the long run, pension benefits will not be higher unless effective policies are implemented to address the weaknesses of the labor market.

The second factor is an ageing population, which is challenging every pension systems around the world and Chile is not the exception. Rapid reductions in fertility rates, coupled with increases in life expectancy, imply that the share of the elderly would steadily grow. This age group has rapidly increased its relative size in recent decades. In 1990, the population of 60+ years was only 9% of the entire population. It increased to 15% in 2015; and it is expected to reach 30% in 2050. This rapid growth means that the quantity of elderly will increase from 2.7 to 6.3 million, making the ratio of active to old to fall from 5 to 1.8. To get a sense of the consequences of an ageing population, consider the following hypothetical scenario: If the active population needed to contribute 20% of their income to a pay-as-you-go scheme in 1990,  then in 2050, it would be necessary for active workers to finance it with more than 50% of their income. This is clearly unfeasible.

The combination of a weak labor market and a rising elderly population implies that pensions have been disappointingly low (relative to the promise made when the system was introduced). The coverage (workers that actually contribute) of the system reaches to 65% of the workforce. Contributions are highly unequal. Workers in the tenth income decile contributed 87% of their working life, while individuals in the bottom quartile contributed only 12%. This is mainly because of a precariousness of the labor market, in which low wages are associated with informality, self-employed workers and unemployed.

In 2013, the system delivered pension benefits to 84% of the elderly population. This figure increased from 79% in 2006 following the introduction of the Basic Solidary Pension (BSP), the minimum level of pension any elderly should receive.

The replacement rate measures the pension benefit as a fraction of the mean income in the ten years before retirement. The current rates are 60% for men and 31% in women if we include the BSP. The corresponding figures without the BSP would be 48 and 24%, respectively. A commission of experts -gathered to analyze the pension system – projected that these figures will be 41% and 34% for the period 2025-2035.[3] These levels are low compared to the average OECD country which is around 60%.[4]

 

The discussion

Any policy reform to the pension system should consider safety nets for the elderly, including improved health care and housing assistance. Apart from that, the pension system must follow some criteria. The two most important ones are that it must deliver reasonable pensions and be sustainable.[5]

1. Chile must move to a State owned and managed pay-as-you-go system and the funds we have already accumulated should go to a common single fund to finance high pensions.

Supporters of this proposal do not want to go back to the old system of “Cajas”. Instead, they propose to concentrate all contributions in a unique state-managed fund, so that the government is in charge of collecting taxes or contributions and delivering pension benefits to retired people. This proposal may be feasible in the short-run (as the system is already funded) but will be unsustainable in the long-run, because the demographic structure implies that at some point in the near future, the total amount of pension benefits would require working people to contribute, at least, 50% of their earnings, as we mentioned before. Hence, the only way to have a sustainable pension system is to increase savings of young workers now. In fact, the whole Chilean economy should start saving more now.

Also, we must decide how and where to save. Some people argue that is not morally acceptable to invest pension funds in the private sector, financing large or foreign firms because these companies usually collude with competitors or pay low wages to their employees. In the first argument, we assert that companies that engage in illegal practices of any type should be sued and prosecuted by the law  regardless of whether they receive pension funds or not. In the second argument, we think that their analysis on wages is flawed. They claim that it is not acceptable to invest in firms that pay low wages because this exacerbates the problem of low wages which, in turn, perpetuates low pensions. This is hardly true.  On the one hand, employees of large companies usually earn higher wages and are much more likely to have a formal job contract than workers in smaller firms. On the other hand, pension funds flowing to large companies may reduce their financial costs (through better cost structure) which could mean that these firms can pay higher wages, and not the other way around. In any case, the objective of supporting small firms and funding entrepreneurs is desirable but it is not the goal of pension systems in any part of the world. Promoting entrepreneurship is beyond the scope of any pension system and hence governments should have tailored policies for this end (one tool for one target). If we want higher pension benefits, funds should go to companies with high returns, independent of their ownership or size.

We think that these funds should be mostly privately managed. In order to ensure profitability and sustainability, we need professionals in charge of them. Since these funds determine not only economic stability for each individual, but also for the whole economy, managers must be experts, with solid technical skills. In this way, we prevent politicians from using these funds for short-run purposes that go beyond the scope of the pension system. Having said this, we acknowledge that the management of funds must be highly regulated, even though it may go against maximizing economic returns.

Finally, we argue that the state must be in charge of complementing the pensions that do not reach a minimum level. This must be financed with part of the individual contribution pillar (not all) and fiscal revenues.

2. It is a problem of parameters and not of how the system is organized.

Even after solving the problems related to the labor market (low participation, low coverage) and demographic structure, we claim that, at least in the short run, it is necessary to change the parameters of the system.In our opinion, the system does not have enough funds.  More money is going out than coming in. And this gap will widen as time goes by.

The contribution rate of 10% of income is too low. We propose to gradually increase this rate to between 15 and 20%. These additional funds would go into both individual accounts and the solidarity pillar, in order to ensure higher pension benefits for everybody.

Efforts should be made in order to ensure that independent workers, who account for 25% of the labor force, contribute to the system. This implies that contributions should be based on total personal income and not only labor income. AFPs must provide innovative contribution schemes for independent workers, taking into account that their incomes are relatively more volatile than that of employees.  Given that most new workers are entering the labor market later (the time they need for college and post-graduate education) and have higher life expectancy, we also propose to progressively extend retirement ages from 65 to 70 for men and from 60 to 70 for women.

We also need to encourage competition among AFPs in order to obtain higher efficiency and better performance. In order to lower the administration fees, we would maintain the public bids of new workers to the system. As more workers join the system, we could expect lower fees and higher returns due to economies of scale.

Currently, each fund manager must reach a capital requirement of 1% of the total amount it is administering, and invest it in the same portfolio of their clients. We think this is not enough to align the incentives of the managers with their client’s, so instead, we propose to link monthly fees to AFP’s performance. This is because sometimes returns could be negative due to mismanagement of the AFP. Also, managers must improve the information delivered to their clients, regarding how their funds are invested and the fees payment. Hopefully, this increased transparency, coupled with better incentives, will improve the returns and the alignment of AFP profits with individual returns. However, these measures would imply that AFPs will not take enough risks and may reduce the returns on funds. To overcome that, we propose to open pension funds investments to a broader set of assets, and an obvious example of this is Public Works.

Finally, we propose to enhance the capabilities of the permanent committee for the evaluation of the pension system. The goal of this committee should be to assess the performance and sustainability of the system on a regular basis. It should be in charge of setting the parameters: amount of contributions, retirement age, and the way the system invests the resources. This committee should be independent of the regulator and the government.

[1] Military personnel had a special different treatment.

[2] CASEN: Encuesta de Caracterización Socioeconómica, in English “Socioeconomic Characterization Survey”.

[3] Its report is the source of most of the figures shown in this article. http://www.comision-pensiones.cl/Documentos/Informe

[4] According to “Pensions at a Glance”, OECD 2015. See the report in http://www.oecd.org/publications/oecd-pensions-at-a-glance-19991363.htm

[5] Respect to OECD pensions’ levels.