Thursday, February 17, 2011

On Social Security

Social security is not just an investment vehicle, it is also an insurance scheme. The insurance portion is that annuity is paid until beneficiary's death, but not a month more. So people who die early subsidize those who live a long life. The law of large number says when the participant of an insurance scheme increases its variance will be reduced, so there is efficiency to be gained from mandatory participation – a smaller variance implies smaller surplus to absorb negative shock. With government as the sole administrator there is also savings compare to private insurers building multiple administrative system and staff for just a portion of the population. Since safety is at the heart of social insurance, pursuing superior investment outcome isn't desirable as it inevitably involves risk taking and will have winners and losers. The goal of all social security is to provide a basic safety net, not a luxury retirement, hence there is a cap on pay that is subject to payroll tax. There is also a small degree of wealth transfer – lower income people will see social security replace a higher proportion of their pre-retirement income, but higher income people will also see a larger check. The bottom line is that society will always have losers, who don't save enough when they are young, squandered their money in bad investments, or become victims of a crime. Social security system is to provide that basic safety net so as to eliminate the need for charity helping senior citizens struggling financially perhaps in the street. Without government mandate individuals cannot by themselves form such an insurance pool, especially considering the ones who need it most is likely the ones refuse to buy in the first place.

Saturday, February 12, 2011

In debt to Keynes

The recent experience of the Great Recession 2007-2009, the ensuing fiscal stimulus package from government around the world, and the Fed's unprecedented monetary policy response, reminds me how much intellectually in debt we are to Keynes. There is no doubt in my mind that without these government effort the world would have plunged into a prolonged depression. Living standard around the world would have fallen so much that hardship and poverty would have been everywhere. This was what happened in the Great Depression. The amazing thing to me is the lack of opposition to these fiscal and monetary policies, other than a few rare but notable exception such as Robert Barro of Harvard. Economic policymakers around the world understand that in a severe financial crisis government should err on the side of doing too much, not doing too little. The mainstream laissez-faire attitude toward market evaporated in a short period of time. Governments around the world coordinated their effort. Policymakers know government directed investment will not be optimal or efficient, but if they don't reverse the tide of the confidence crisis, the loss in output and employment will be huge and ten times more wasteful than the relative inefficiency of public investment over private investment.

What changed the mind of policymakers since the Great Depression of 1930s? Over the past 80 years there is an onslaught of attack on Keynesian thinking. Friedrich Hayek called Keynesian thinking as “the road to serfdom”. Milton Friedman once said: “the great advances of civilization, whether in architecture or painting, in science or literature, in industry or agriculture, have never come from centralized government.” Politician on the right is always calling for a smaller government. But I think deep down they understand Keynes is right on the cause of the Great Depression. They know Keynes is right on government response to financial crisis. Keynes wasn't advocating a central planning government in the sense of communism. He is saying, when you have massive unemployment as high as 25 percent of the population and rampant poverty, it is less wasteful to use the government investment on whatever endeavor than do nothing. Infrastructure building creates job. Scientific research creates job. Even pyramid building creates job. And after that pyramid or monument is built, private consumption and investment will return to normal. Isn't this what just happened since the last quarter of 2007?

Standing today in 2011 when economy is on path to full recovery, we are all in debt to Keynes. Without his insight and compelling argument policymakers around the world might have the wrong action and we would have been doomed for a generation. We shall never forget this important lesson.

Tuesday, February 08, 2011

Saving and Spending

Mom's personal finance strategy has always been "denying herself". She has crimped her consmumption her whole life. Is her frugality rewarded? Or just squandered by others? She doesn't have many friends, because she spent her whole life working and saving. Maybe it is time to be generous.

The hardest part of economic decision is that you have to not just save wisely, but also invest and spend wisely. How to spend your wealth takes as much effort and planning as how to build it. Do you spend it on travel, dinning, and making friends? $100M gift to the public library? $1B gift to eradicate malaria? It is no easy task to spend it wisely.