Tuesday, September 20, 2011

Forget the Future? Pension Uncertainty and Scaling Back Today's Consumption

When I was an undergraduate, I was taught that in a closed economy that C+I+G=Y.   Given that I'm back at the LSE, I've been pondering this deep macro identity.   Government spending, G, is going to decline as we try to cut the deficit.   I, private investment,  is frozen as firms are puzzled about what will happen next so that leaves "C" --- consumer spending.

Won't consumers be kind enough to spend our way out of recession?   Ricardian Equivalence posits that forward looking consumers anticipate coming tax increases and this expectation that their permanent income is lower than reflected by today's income leads consumers to cut back consumption now and save today.

Now a pinch more bad news.   Today's Daily Telegraph reports that 60% of individuals surveyed in the UK do not believe that their pension will give them enough money to live on in retirement.   Now, I don't know where this expectation comes from but if a substantial percentage of U.S adults of working age believe this then they will respond by scaling back their consumption today to save more for the future.

It is too strong to call this a self fulfilling prophesy but this is an ugly case highlighting how expectations of the medium term influence choices today.

In the Keynesian consumption function, men are monkeys who do not ponder the future.  In that model,  today's consumption is solely a function of today's income.  Would our economy be in stronger shape if we had less of an ability to imagine the future?  Must we evolve into monkeys?

2 comments :

Jeff said...

Having noted this theoretical equivalence, Ricardo stated that "the people who paid the taxes never so estimate them, and therefore do not manage their private affairs accordingly."

In other words, immediately upon proposing this theory, Ricardo immediately dismissed it as at odds with reality.

Indeed, econometric tests have borne this out. So I wouldn't pay much attention to Ricardian equivalence.

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