The ongoing difficulties in overcoming the persistence of debt-to-GDP ratio in EU countries highlight the question whether the European Monetary Union can survive the set of shocks which prevailed since the 2008/2009 economic and financial crisis. Recently, European Commission has prested the 2010 review of public finances in EMU (link), suggesting that macroeconomic outlook for Eurozone economies has deteriorated in the light of a growing debt-to-GDP ratio.
The launch of government bailouts in various European countries has added considerable amount to the stock of public debt across the Eurozone. Since 2008/2009, general government balance in Eurozone countries has continually resulted in persistent government deficits which further added to the stock of debt. Since public debt is by definition the sum of previous deficits, the European macroeconomic outlook suffers significantly from downgraded stability of public debt.
The anatomy of sluggish economic recovery in Eurozone consists of different set of economic policies. Countries at the European periphery (Portugal, Ireland, Greece, Italy, Spain) seem to be hit most by the sluggish economic recovery. From the viewpoint of macreconomic stability, the economic policymakers in these countries have pursued the most discretionary economic policies to mitigate the effects of decline in GDP on employment, earnings and tax revenues. In addition, highly expansionary monetary policy by the European Central Bank provided a bulk of quantitative easing, resulting flooding liquidity to supplement the interbank lending and, hence, to contain the effect of overleveraged financial sector on macroeconomic stability. In Ireland, income per capita in 2010 notably decline back to 2004 level (link). As I previously emphasized in one of my previous posts (link), the depth of the economic crisis in Ireland is largely attributed to the overleveraged banking sector, vulnerable to the interbank interest rate increases. Since the sovereign CDS spread on Ireland exceeded 500 basis points in late September this year, the Irish public finance outlook deteriorated significantly in the light of the innate ability of the Irish government to bailout Anglo-Irish Bank. Recently, the IMF estimated (link) that by 2012, Irish debt-to-GDP ratio would reach 67 percent, up from 12 percent in 2005.
A prudent reduction in debt-to-GDP would be accomplished only under restrictive fiscal policy based on the reduction in government spending and a permanent fiscal rule on budget surplus at a given target level. If Irish government set the surplus target at 3 percent of GDP in the next ten years, debt-to-GDP ratio could be considerably reduced within the range of Maastricht fiscal criteria.
The macroeconomic outlook in peripheral countries suffers from high fiscal expenditures and rigid labor market institutions. By 2012, Portugal's debt-to-GDP ratio is expected to reach nearly 85 percent of GDP. In addition to soaring public debt, the Mediterranean part of the EMU suffers heavily from high unemployment rate. Eurostat recently reported that, by October 2010, the unemployment rate in Spain reached an astonishing 20.7 percent. Double-digit unemployment rate in Spain, Greece (12.2 percent) and Portugal (11 percent) hamper the economic recovery since, in the past, these countries exercised expansionary fiscal policy and the policy of automatic stabilizers to mitigate the effects of high unemployment on aggregate consumption decline. In the aftermath of financial crisis, these countries experienced recessionary output gap in which economic contraction is marred by unchanged inflationary pressures.
Since EMU countries withheld domestic currencies and adhered the adoption of the Euro, the macroeconomic adjustment to the recovery is possible only by a prudent fiscal policy. High unemployment rates and a persistent divergence of economic policies in EMU countries could substantially increase discretionary fiscal policies that would eventually result in the serious possibility of country default. The economic crisis in Greece resulted in 11 percent cumulative GDP decline between 2010 and 2012. In the same period, government net debt is expected to reach the 120 percent of GDP thresold. A divergence between Member States towards highly discretionary fiscal policy would probably alleviate the persistence of high unemployment but at the expense of bold increase in the rate of inflation as well as in the persistence of debt-to-GDP ratio and large government imbalances. Hence, the survival of the Eurozone would depend on the ability of EU Member States to adjust government balance by reducing fiscal expenditure and adopt the fiscal rule to pursue fiscal surplus in the coming years as to reduce the stock of public debt.
Even though a common fiscal policy could accomplish the goals of stabilization policy, the mitigation of fiscal asymmetries would be easily accomplished by labor market integration. A currency union between different countries implies integrated and assimilated labor markets under relatively homogenous preferences. It would be nearly impossible to envision the European Monetary Union without these key macroeconomic features.
Wednesday, January 5, 2011
Sunday, January 2, 2011
Public pension crisis in OECD countries
The central aim of my bachelor's thesis is to demonstrate the unsustainability of public pension system in OECD countries in the longer run through the lens of a rigorous theoretical and empirical analysis.
The origins of contemporary public pension schemes date back to 19th century when Bismarckian Germany in 1881 first adopted a universal old-age public pension system based on pay-as-you-go (PAYG) funding principle. The principle itself captures full advantages of high (stationary) population growth rate. In the simplest form, PAYG pension scheme is based on the notion of generational solidarity upon which current generations pay mandatory social security contribution into the public scheme. Aggregate contributions are then paid out to current retirees. The cycle is then expanded through generations. However, PAYG funding scheme is sustainable as long as the population growth is high and above the marginal productivity of the capital. Back in 19th century, public pension schemes were adopted under unrealistic assumptions about future population prospects. In 19th century, advanced countries experienced high population growth rate, high fertility rate and an extremely low share of dependent old population that was receiving universal old-age support from PAYG pension schemes. These set of assumptions was crucial to the stability of government-provided old-age support embodied in the public pension schemes.
The sustainability of PAYG pension system requires the equivalence of population growth rate and real interest rate. In the early 20th century, the advanced world shifted towards aging population, declining fertility rates and lower labor market entry rate. In broad terms, a growing old-age dependency ratio led to the pure disequilbrium effects. In a theoretical framework, I re-examined the neoclassical framework of lifecycle hypotheses embodied in Samuelson and Cass-Yaari models of life-cycle utility maximization. The lifecycle hypothesis is based upon the assumption of the three-period model where individuals maximize the consumption in the course of a lifetime. In the first period, individuals do not discount the future consumption since, in this period, individuals acquire the human capital. In the second period individuals enter the working age and discount the future consumption. Hence, in the third period, individuals retire consume the output produced in the working-age period. Since future discounting is compounded, the lifetime consumption increases geometrically. In purely analytical terms, the individuals maximize the utility of consumption through time preference rate.
Considering the abovementioned equivalence between population growth rate and real interest rate, the stability of the equilibria requires the period discount rate to equal the population growth rate. If population growth rate decreases, the stability of the equilibria requires that individuals decrease the future discount rate by the same rate to keep the PAYG pension system within the theoretical limit. The rigorous theoretical formulation of the neoclassical model of lifetime consumption, which essentially captures the necessary conditions for equilibrium stability of public pension schemes, had been put forth by Paul A. Samuelson in his seminal contribution to the theoretical foundations of stationary "PAYG" public pension scheme .
In the course of the last decades, OECD countries have experienced a significant drop in fertility rates, population growth and, under the political climate of social democracy, a widespread adoption of early retirement schemes and generous social security benefits. In addition, labor market exit age dropped significantly, initiating a trend towards the unprecendent growth of generational indebtedness.
The OECD estimated that between 2000 and 2050, old-age dependency ratio is forecast to increase to the largest extent in Japan (193 percent), Spain (136 percent), Portugal and Greece (135 percent). The astonishing increase in the estimated old-age dependency ratio directly reflects the declining fertility rate in OECD countries from 1960s onwards. I estimated the ratio of fertility rate between 1960-1970 and 2000-2006 for OECD countries at around 2, which means that average fertility rate between 1960-1970 was twice the fertility rate between 2000-2006. The highest fertility ratios were found in Spain (2.23), Italy (1.96), Ireland (2.00) while the lowest ratios were found in Denmark (1.37), Netherlands (1.72) and the United States (1.46).
High and stable effective retirement age is the main assumption underlying the stationary stability of PAYG pension system. In the 20th and 21st century, OECD countries have experienced an unprecendent decline in effective retirement age. Blöndal and Scarpetta (2002) estimated the decline in labor market exit age for OECD countries between 1960 and 1995. The female labor market exit age had declined significantly in Ireland (10.7 years), Spain (9.1 years) and Norway (8.8 years). Male labor market exit age exerted persistent decline in all developed OECD countries except for Iceland. The exit age declined significantly in the Netherlands (7.3 years) and Spain (6.5 years).
In a large part, declining labor market exit age has confluenced the rapid growth of unemployment and disability benefits and early retirement incentives from the second half of the 20th century onwards. As the OECD correctly contemplated, in a number of countries, disability pensions and unemployment benefits can be used as de facto early retirement schemes. In a large part, widespread growth of early retirement schemes and implicit incentives for moral hazard in retiring too early via unemployment and disability schemes is held responsible by generous welfare states in the aftermath of the World War II.
When I examined various features affecting early retirement choices, I came across an interesting finding. I regressed labor market exit age and marginal tax rate in a cross section of 23 OECD countries in 2007. I estimated the relationship between exit age and marginal tax rate using a classical OLS linear regression model. The estimate suggests that, holding all other factors constant, if marginal tax rate increases by 1 percentage point, average labor market exit age decreases by 1.88 months. Surprisingly, 51.74 percent of sample variation is explained by marginal tax rate alone. The sample constant is statistically significant, suggesting that if the hypothetical marginal tax rate were zero, the average labor market exit age in randomly chosen country from OECD sample would be 69.65 years. The sample constant is consistent with a prior theoretical expectations since it concurs with the "substitution effect" hypothesis that higher marginal tax rate leads to lower labor supply and fewer working hours.
Source: T.T. Herbertsson & J.M. Orszag, The Cost of Early Retirement in OECD, 2001. OECD, Pensions at Glance, 2009.
Fiscal imbalances arising from unsustainable PAYG public pension systems in OECD countries cannot be assessed without a sufficient estimate of economic costs of unfunded pension liabilities. I approximated the cost of early retirement using Auerbach-Kotlikoff-Gokhale (1999) methodology that directly estimates the size of generational imbalances created by public social security systems. Large and rapidly unsustainable net pension liabilities occured in late 1980s. Van den Noord and Herd (1993) estimated the size of net pension liabilities in seven major OECD countries. The results suggest that continental European countries have had the largest net pension liabilities in terms of GDP. The size of pension liabilities in France and Italy had been about 2.5 times the size of their respective GDPs and twice the stock of the public debt.
Gokhale (2008) directly estimated fiscal imbalances arising from unfunded pension liabilities to current and prospective generations. The size of generational fiscal imbalance, as a share of the GDP, is extremely large and rapidly unsustainable in all OECD countries. In fact, the size of the imbalance is the most severe in Greece (875 percent of the GDP), France, Finland and the Netherlands (500 percent of the GDP) while it is more than twice the size of the GDP in all OECD countries except for the United States, Canada, Australia and New Zealand.
Source: J. Gokhale, Measuring Unfunded Obligations of European Countries, 2009.
I built the econometric model of public pension expenditure for a cross section of 23 OECD countries in 2007 to assess which variables might explained the cross-country variation in public pension expenditures. I've been aware of the possible drawbacks of choosing a cross-section model since it might be vulnerable to specification errors and the unbiasedness of regression coefficients. To account for possible specification bias, I conducted Kolmogorov-Smirnov, Shapiro-Wilk and Jarque-Bera normality tests. By performing normality tests, I have examined whether the normality assumption of normally distributed error terms is valid in the studied sample of 23 OECD countries considering error terms as identically and independently distributed.
In the set of explanatory variables that might yield consistent and robust estimates of regression coefficients I chose 10 various demographic, economic and institutional independent variables. Apart from demographic and economic variables, institutional variables are dichotomous since the institutional features can be captured by binary modes of choice. The dependent variable is the size of public pension expenditures in the share of the GDP.
The results suggest that public pension expenditures are positively correlated with the share of population aged 65 and older (0.746**), difference in life expectancy after age 65 between 1960 and 2005 (0.477*) and dichotomous variable for continental European countries (0.697**) where * and ** indicate the statistical significant of the sample correlation coefficient at the 5% and 1% level. The estimates suggests that the probability of higher pension expenditures in the share of the GDP is likely to occur in a continental European country known for a relatively large share of older population and a high difference in life expectancy after age 65 between 1960 and the present. On the other hand, public pension expenditures are negatively correlated with average effective retirement age (-0.475**), private pension funds as a share of GDP (-0.658**), labor market exit age (-0.523**), dichotmous variable for Anglo-Saxon countries (-0.544**) and a dichotomous variable for private pension system (-0.672**), where ** denotes the statistical significant of the sample correlation coefficient at the 1% level. Again, the estimates suggest that the probability of lower pension expenditure is likely to occur if a randomly chosen country from the OECD sample is Anglo-Saxon and has a high effective retirement age, large private pension funds as a share of the GDP, high labor market exit age and a mandatory private pension system. The coefficients suggest that in repeated sampling, the estimated sample correlation coefficient will include the true or correct population value in 99 percent of cases.
I conducted the econometric model which consisted of 8 regression specifications. I chose double-logarithmic model which yields direct elasticities as regression coefficients. However, I added two exceptions. In regression specifications 5 and 6, I chose a mixed specification mostly due to the inclusion of private pension funds (assets) variable in the regression specification. Unfortunately, but the share of private pension funds in Greece in 2007 equals 0 percent of the GDP which does not enable the researcher to apply double-logarithmic model as the basis of regression specification.
The estimates suggest that the share of population aged 65 and older is statistically singificantly positively related to the share of public pension expenditures in the GDP. Hence, the elasticity of public pension expenditures with respect to effective retirement age ranges from -1.465 to -4.935, suggesting that an increase in effective retirement age by an additional year leads to per unit increase in public pension expenditures by more than a unit increase in the share of the GDP. The coefficient of private pension funds is highly statistically significant. The elasticity of public pension expenditures with respect to private pension funds (as a share of the GDP) ranges from -0.34 to -0.38 and is statistically significant at the 1% level. The elasticity suggests that a 10 percentage point increase in the share of private pension funds reduces the share of public pension expenditures in the GDP, on impact, by 3.4-3.8 percent, holding all other factors constant. In addition, the estimates of coefficients for dichotomous variables suggest the following: the probability of higher public pension expenditures (as a share of GDP) is likely to occur in continental European countries with mandatory private pension system. Five estimates of dichotomous coefficients are statistically significant at the less than 10% level.
The significance of dichotomous (dummy) coefficients has been tested by beta coefficient analysis to rank the magnitudes of separate effects of explanatory variables on public pension expenditures as dependent variable. The results suggest that continental European countries are significantly more likely to face higher public pension spending in the share of GDP compared to Anglo-Saxon countries.
Earlier I mentioned the necessity of normality assumption in yielding robust, consistent and unbiased estimates of regression coefficients. The assumption has been questioned by conducting Kolmogorov-Smirnov test (K-S), Jarque-Bera test (J-B) and Shapiro-Wilk (S-W) normality test. The aim of the testing the normality assumption is to observe whether error terms distribute normally so that estimated test statistics, standard errors and confidence intervals are reliable. In setting test statistic, I set the normality assumption as null hypothesis. The results from K-S, J-B and S-W tests show that the null hypothesis cannot be rejected at 5% level, suggesting that the normality assumption is valid in the studied sample. Hence, test statistics, standard errors and confidence intervals are both valid and reliable.
The meaningful question to evaluate the prospects of the coming public pension crisis is how to reverse the growth of fiscal imbalances and reform public pension system as to avoid erratic generational indebtedness. Aging population and the growth of old-age dependency ratio trigger an enormous future burden on public finances in OECD countries. Lower fertility rate and population growth shall place an incurable burden on the stability of PAYG public pension systems. The estimates suggest that life-expectancy after the age of 65 is likely to increase by 2050 and gradually approach the age of 90 for both male and female. Assuming the effective retirement age is 65, the remaining life expectancy is 25 years or almost one-third of the average lifetime. As Alemayehu and Warner (2004) suggest: "Old-age health care costs thus will impose increasingly severe pressure on private finances and government coffers. Indeed, applying our age-specific estimates to the age distribution anticipated for the year 2030, we find that if nothing is done to alter current patterns of health care, per capita health care expenditures will rise by one-fifth due to population aging alone."
The long-term pension reform that aging societies of the West should undertake is a complementary measures of three key policy features of the reform.
First, the transition to fully-funded retirement savings accounts is the only viable and sound pension reform that can alleviate the damage generated by the growing fiscal imbalances. The theoretical foundation of the transition from public pension systems to fully-funded pension system has been laid down by Feldstein and Liebman (2001). The authors derived an algebraic solution which suggests that keeping a PAYG public pension system does not attenuate the persistence of a growing demographic pressure on the stability of public pension system. As I discussed earlier, PAYG system crucially depends on three key assumptions: high fertility rate, very low share of population older 65+ and high population growth. These assumptions are incompatible with actual demographic parameters and, hence, OECD countries should undertake a drastic transition towards fully-funded pension systems based on individual savings accounts. Otherwise, the growing demographic pressure will inevitably result in the exponential growth of generational debt, creating an enormous deadweight loss for current and prospective generations.
Fully-funded pension system is based on the premise of investing pension contributions into the capital market, earning a compound interest over time. The stock of individual's lifetime earnings is paid in the form of annuities upon individual's withdrawal from the labor market. In addition, there is a growing disparity between the implicit return of PAYG public pension system and real rate of return in the capital market. Under realistic assumptions, such as that the marginal product of capital (MPK) is below the welfare-maximizing level and the real rate of return exceeds the implicit return from PAYG system, fully-funded pension system would not create a deadweight consumption loss to the working-age population. In fact, Feldstein and Liebman (2001) derived an analytic solution for the transition to fully-funded pension system in which the transition induces a short-term consumption loss in the next period while, at the same time, it creates a geometrically-growing future consumption for both retired and working-age population.
The only remaining question is whether the real rate of return would compensate the consumption loss of working-age population and, hence, increase the stock of future consumption to all generations. According to Feldstein and Liebman (2001), assuming 6.5 percent inflation-adjusted rate of return, the payroll cost of fully-funded pension system would represent only 27 percent of the payroll cost incured under PAYG public pension system. Tax rate, required to bear the cost of current stock of pension liabilities is 12.4 percent respectively.
According to Congressional Budget Office, the average real rate of return for large-company stocks between 1926 and 2000 is 7.7 percent, 9.0 percent of small-company stocks and 2.2 percent for long-term Treasury bonds. Feldstein (1997) estimated that PAYG implicit rate of return is 2.6 percent.
Assume an individual wants to maximize the lifetime earnings in the capital market. An individual is offered 2.6 percent implicit return from PAYG system. The individual enters the labor market at certain age, say 25, and intends to retire upon the age of 65. Assume he invests $10.000 annually in the capital market to create retirement annuities upon labor market withdrawal. Assuming the implicit rate of return (2.6 percent), the stock of overall annuity would be 10 times the initial investment in 90 years. Assuming the average long-run real rate of return from large-company stocks (7.7 percent), the the overall annuity would be 10 times the initial stock of investment in 31 years. Therefore, the individual would reach the desired level of lifetime earnings at the age of 56 or 9 years before the targeted retirement age.
I assumed the distribution of lifetime investment portfolio is weighted average of availible asset types: large-company stocks (33 percent), small-company stocks (19 percent), long-term corporate bonds (20 percent), long-term Treasury bonds (20 percent) and 3-month Treasury bills (8 percent). According to the average annual real rates of return in the United States (1926-2000), I calculated the weighted average real rate of return (5.247 percent). Investing $10.000 annually at the age of 25 would buy $100.000 annuity at 5.247 real rate of return in 45 years (the age of 70) compared to 90 years (the age of 115) under the PAYG implicit rate of return (2.6 percent). Of course, the time to buy the annuity would shift alongside the changing composition of portfolio.
In addition, OECD countries should immediately increase the effective retirement age. I believe the solution suggested by Gary Becker is both meaningful but sustainable in reversing the growth of generational debt. Becker (2010) suggested "One simple and attractive rule would be to raise retirement age by an amount that makes the ratio of years spent in retirement to years spent working equal to the ratio that existed at the beginning of the social security system."
When President Roosevelt signed the notorious Social Security Act in 1935, the normal retirement age was 65. However, life expectancy after the age of 65 was significantly lower than is today. In 1940, average life expectancy after 65 in the U.S was 13.7 years. In 2006, it stood at 18.6 years, according to OECD. In 1935, the average life expectancy at birth in the United States was 61.7 years. We assume that individuals in 1935 worked for 35 years and spent 12 years in retirement. The ratio is thus 0.4 (12/ 35=0.34). Today, if individuals retire at the age of 65, they can expect further 18.6 years in retirement. To equalize the ratio to the 1935 level, (18.6/x=0.34), individuals should spend 54.7 years working. The estimate time is an equivalent measure of years required to spend working if PAYG public pension system is left intact. Assuming the individuals enter the labor market at the age of 25, then the expected effective retirement age is the age of 80.
In the long run, PAYG public pension system is unsustainable since demographic parameters do not suffice the assumptions under which the PAYG system is possible without distortions of labor supply incentives. The future of OECD countries will be marked by aging population, lower fertility rates and a growing demographic pressure on public finances. Without bold and decisive pension reform, OECD countries will experience increasing pension deficits and, hence, an explosive growth of generational indebtedness.
Parametric pension reforms are not a substitute for the postponement of paradigmatic pension reform. Thus, implementing the transition to fully-funded pension system essentially requires higher effective retirement age. A comprehensive pension reform cannot be made possible without these measures. At last, but not least, the major challenge in the systematic pension reform in OECD countries to address the burden of global aging, is whether political courage will withstand the pressure of interest groups to maintain the status quo of early retirement incentives. Nonetheless, eliminating early retirement incentives is the essential step towards creating retirement system without perverse incentives to retire too early. Unless political leaders encourage a transition to fully-funded pension system, OECD countries will be unable to withstand the deadly consequences of an enormous generational indebtedness.
The origins of contemporary public pension schemes date back to 19th century when Bismarckian Germany in 1881 first adopted a universal old-age public pension system based on pay-as-you-go (PAYG) funding principle. The principle itself captures full advantages of high (stationary) population growth rate. In the simplest form, PAYG pension scheme is based on the notion of generational solidarity upon which current generations pay mandatory social security contribution into the public scheme. Aggregate contributions are then paid out to current retirees. The cycle is then expanded through generations. However, PAYG funding scheme is sustainable as long as the population growth is high and above the marginal productivity of the capital. Back in 19th century, public pension schemes were adopted under unrealistic assumptions about future population prospects. In 19th century, advanced countries experienced high population growth rate, high fertility rate and an extremely low share of dependent old population that was receiving universal old-age support from PAYG pension schemes. These set of assumptions was crucial to the stability of government-provided old-age support embodied in the public pension schemes.
The sustainability of PAYG pension system requires the equivalence of population growth rate and real interest rate. In the early 20th century, the advanced world shifted towards aging population, declining fertility rates and lower labor market entry rate. In broad terms, a growing old-age dependency ratio led to the pure disequilbrium effects. In a theoretical framework, I re-examined the neoclassical framework of lifecycle hypotheses embodied in Samuelson and Cass-Yaari models of life-cycle utility maximization. The lifecycle hypothesis is based upon the assumption of the three-period model where individuals maximize the consumption in the course of a lifetime. In the first period, individuals do not discount the future consumption since, in this period, individuals acquire the human capital. In the second period individuals enter the working age and discount the future consumption. Hence, in the third period, individuals retire consume the output produced in the working-age period. Since future discounting is compounded, the lifetime consumption increases geometrically. In purely analytical terms, the individuals maximize the utility of consumption through time preference rate.
Considering the abovementioned equivalence between population growth rate and real interest rate, the stability of the equilibria requires the period discount rate to equal the population growth rate. If population growth rate decreases, the stability of the equilibria requires that individuals decrease the future discount rate by the same rate to keep the PAYG pension system within the theoretical limit. The rigorous theoretical formulation of the neoclassical model of lifetime consumption, which essentially captures the necessary conditions for equilibrium stability of public pension schemes, had been put forth by Paul A. Samuelson in his seminal contribution to the theoretical foundations of stationary "PAYG" public pension scheme .
In the course of the last decades, OECD countries have experienced a significant drop in fertility rates, population growth and, under the political climate of social democracy, a widespread adoption of early retirement schemes and generous social security benefits. In addition, labor market exit age dropped significantly, initiating a trend towards the unprecendent growth of generational indebtedness.
The OECD estimated that between 2000 and 2050, old-age dependency ratio is forecast to increase to the largest extent in Japan (193 percent), Spain (136 percent), Portugal and Greece (135 percent). The astonishing increase in the estimated old-age dependency ratio directly reflects the declining fertility rate in OECD countries from 1960s onwards. I estimated the ratio of fertility rate between 1960-1970 and 2000-2006 for OECD countries at around 2, which means that average fertility rate between 1960-1970 was twice the fertility rate between 2000-2006. The highest fertility ratios were found in Spain (2.23), Italy (1.96), Ireland (2.00) while the lowest ratios were found in Denmark (1.37), Netherlands (1.72) and the United States (1.46).
High and stable effective retirement age is the main assumption underlying the stationary stability of PAYG pension system. In the 20th and 21st century, OECD countries have experienced an unprecendent decline in effective retirement age. Blöndal and Scarpetta (2002) estimated the decline in labor market exit age for OECD countries between 1960 and 1995. The female labor market exit age had declined significantly in Ireland (10.7 years), Spain (9.1 years) and Norway (8.8 years). Male labor market exit age exerted persistent decline in all developed OECD countries except for Iceland. The exit age declined significantly in the Netherlands (7.3 years) and Spain (6.5 years).
In a large part, declining labor market exit age has confluenced the rapid growth of unemployment and disability benefits and early retirement incentives from the second half of the 20th century onwards. As the OECD correctly contemplated, in a number of countries, disability pensions and unemployment benefits can be used as de facto early retirement schemes. In a large part, widespread growth of early retirement schemes and implicit incentives for moral hazard in retiring too early via unemployment and disability schemes is held responsible by generous welfare states in the aftermath of the World War II.
When I examined various features affecting early retirement choices, I came across an interesting finding. I regressed labor market exit age and marginal tax rate in a cross section of 23 OECD countries in 2007. I estimated the relationship between exit age and marginal tax rate using a classical OLS linear regression model. The estimate suggests that, holding all other factors constant, if marginal tax rate increases by 1 percentage point, average labor market exit age decreases by 1.88 months. Surprisingly, 51.74 percent of sample variation is explained by marginal tax rate alone. The sample constant is statistically significant, suggesting that if the hypothetical marginal tax rate were zero, the average labor market exit age in randomly chosen country from OECD sample would be 69.65 years. The sample constant is consistent with a prior theoretical expectations since it concurs with the "substitution effect" hypothesis that higher marginal tax rate leads to lower labor supply and fewer working hours.
The cost of early retirement in OECD countries
Source: T.T. Herbertsson & J.M. Orszag, The Cost of Early Retirement in OECD, 2001. OECD, Pensions at Glance, 2009.Fiscal imbalances arising from unsustainable PAYG public pension systems in OECD countries cannot be assessed without a sufficient estimate of economic costs of unfunded pension liabilities. I approximated the cost of early retirement using Auerbach-Kotlikoff-Gokhale (1999) methodology that directly estimates the size of generational imbalances created by public social security systems. Large and rapidly unsustainable net pension liabilities occured in late 1980s. Van den Noord and Herd (1993) estimated the size of net pension liabilities in seven major OECD countries. The results suggest that continental European countries have had the largest net pension liabilities in terms of GDP. The size of pension liabilities in France and Italy had been about 2.5 times the size of their respective GDPs and twice the stock of the public debt.
Gokhale (2008) directly estimated fiscal imbalances arising from unfunded pension liabilities to current and prospective generations. The size of generational fiscal imbalance, as a share of the GDP, is extremely large and rapidly unsustainable in all OECD countries. In fact, the size of the imbalance is the most severe in Greece (875 percent of the GDP), France, Finland and the Netherlands (500 percent of the GDP) while it is more than twice the size of the GDP in all OECD countries except for the United States, Canada, Australia and New Zealand.
Fiscal imbalance in OECD countries
Source: J. Gokhale, Measuring Unfunded Obligations of European Countries, 2009.I built the econometric model of public pension expenditure for a cross section of 23 OECD countries in 2007 to assess which variables might explained the cross-country variation in public pension expenditures. I've been aware of the possible drawbacks of choosing a cross-section model since it might be vulnerable to specification errors and the unbiasedness of regression coefficients. To account for possible specification bias, I conducted Kolmogorov-Smirnov, Shapiro-Wilk and Jarque-Bera normality tests. By performing normality tests, I have examined whether the normality assumption of normally distributed error terms is valid in the studied sample of 23 OECD countries considering error terms as identically and independently distributed.
In the set of explanatory variables that might yield consistent and robust estimates of regression coefficients I chose 10 various demographic, economic and institutional independent variables. Apart from demographic and economic variables, institutional variables are dichotomous since the institutional features can be captured by binary modes of choice. The dependent variable is the size of public pension expenditures in the share of the GDP.
The results suggest that public pension expenditures are positively correlated with the share of population aged 65 and older (0.746**), difference in life expectancy after age 65 between 1960 and 2005 (0.477*) and dichotomous variable for continental European countries (0.697**) where * and ** indicate the statistical significant of the sample correlation coefficient at the 5% and 1% level. The estimates suggests that the probability of higher pension expenditures in the share of the GDP is likely to occur in a continental European country known for a relatively large share of older population and a high difference in life expectancy after age 65 between 1960 and the present. On the other hand, public pension expenditures are negatively correlated with average effective retirement age (-0.475**), private pension funds as a share of GDP (-0.658**), labor market exit age (-0.523**), dichotmous variable for Anglo-Saxon countries (-0.544**) and a dichotomous variable for private pension system (-0.672**), where ** denotes the statistical significant of the sample correlation coefficient at the 1% level. Again, the estimates suggest that the probability of lower pension expenditure is likely to occur if a randomly chosen country from the OECD sample is Anglo-Saxon and has a high effective retirement age, large private pension funds as a share of the GDP, high labor market exit age and a mandatory private pension system. The coefficients suggest that in repeated sampling, the estimated sample correlation coefficient will include the true or correct population value in 99 percent of cases.
I conducted the econometric model which consisted of 8 regression specifications. I chose double-logarithmic model which yields direct elasticities as regression coefficients. However, I added two exceptions. In regression specifications 5 and 6, I chose a mixed specification mostly due to the inclusion of private pension funds (assets) variable in the regression specification. Unfortunately, but the share of private pension funds in Greece in 2007 equals 0 percent of the GDP which does not enable the researcher to apply double-logarithmic model as the basis of regression specification.
The estimates suggest that the share of population aged 65 and older is statistically singificantly positively related to the share of public pension expenditures in the GDP. Hence, the elasticity of public pension expenditures with respect to effective retirement age ranges from -1.465 to -4.935, suggesting that an increase in effective retirement age by an additional year leads to per unit increase in public pension expenditures by more than a unit increase in the share of the GDP. The coefficient of private pension funds is highly statistically significant. The elasticity of public pension expenditures with respect to private pension funds (as a share of the GDP) ranges from -0.34 to -0.38 and is statistically significant at the 1% level. The elasticity suggests that a 10 percentage point increase in the share of private pension funds reduces the share of public pension expenditures in the GDP, on impact, by 3.4-3.8 percent, holding all other factors constant. In addition, the estimates of coefficients for dichotomous variables suggest the following: the probability of higher public pension expenditures (as a share of GDP) is likely to occur in continental European countries with mandatory private pension system. Five estimates of dichotomous coefficients are statistically significant at the less than 10% level.
The significance of dichotomous (dummy) coefficients has been tested by beta coefficient analysis to rank the magnitudes of separate effects of explanatory variables on public pension expenditures as dependent variable. The results suggest that continental European countries are significantly more likely to face higher public pension spending in the share of GDP compared to Anglo-Saxon countries.
Earlier I mentioned the necessity of normality assumption in yielding robust, consistent and unbiased estimates of regression coefficients. The assumption has been questioned by conducting Kolmogorov-Smirnov test (K-S), Jarque-Bera test (J-B) and Shapiro-Wilk (S-W) normality test. The aim of the testing the normality assumption is to observe whether error terms distribute normally so that estimated test statistics, standard errors and confidence intervals are reliable. In setting test statistic, I set the normality assumption as null hypothesis. The results from K-S, J-B and S-W tests show that the null hypothesis cannot be rejected at 5% level, suggesting that the normality assumption is valid in the studied sample. Hence, test statistics, standard errors and confidence intervals are both valid and reliable.
The meaningful question to evaluate the prospects of the coming public pension crisis is how to reverse the growth of fiscal imbalances and reform public pension system as to avoid erratic generational indebtedness. Aging population and the growth of old-age dependency ratio trigger an enormous future burden on public finances in OECD countries. Lower fertility rate and population growth shall place an incurable burden on the stability of PAYG public pension systems. The estimates suggest that life-expectancy after the age of 65 is likely to increase by 2050 and gradually approach the age of 90 for both male and female. Assuming the effective retirement age is 65, the remaining life expectancy is 25 years or almost one-third of the average lifetime. As Alemayehu and Warner (2004) suggest: "Old-age health care costs thus will impose increasingly severe pressure on private finances and government coffers. Indeed, applying our age-specific estimates to the age distribution anticipated for the year 2030, we find that if nothing is done to alter current patterns of health care, per capita health care expenditures will rise by one-fifth due to population aging alone."
The long-term pension reform that aging societies of the West should undertake is a complementary measures of three key policy features of the reform.
First, the transition to fully-funded retirement savings accounts is the only viable and sound pension reform that can alleviate the damage generated by the growing fiscal imbalances. The theoretical foundation of the transition from public pension systems to fully-funded pension system has been laid down by Feldstein and Liebman (2001). The authors derived an algebraic solution which suggests that keeping a PAYG public pension system does not attenuate the persistence of a growing demographic pressure on the stability of public pension system. As I discussed earlier, PAYG system crucially depends on three key assumptions: high fertility rate, very low share of population older 65+ and high population growth. These assumptions are incompatible with actual demographic parameters and, hence, OECD countries should undertake a drastic transition towards fully-funded pension systems based on individual savings accounts. Otherwise, the growing demographic pressure will inevitably result in the exponential growth of generational debt, creating an enormous deadweight loss for current and prospective generations.
Fully-funded pension system is based on the premise of investing pension contributions into the capital market, earning a compound interest over time. The stock of individual's lifetime earnings is paid in the form of annuities upon individual's withdrawal from the labor market. In addition, there is a growing disparity between the implicit return of PAYG public pension system and real rate of return in the capital market. Under realistic assumptions, such as that the marginal product of capital (MPK) is below the welfare-maximizing level and the real rate of return exceeds the implicit return from PAYG system, fully-funded pension system would not create a deadweight consumption loss to the working-age population. In fact, Feldstein and Liebman (2001) derived an analytic solution for the transition to fully-funded pension system in which the transition induces a short-term consumption loss in the next period while, at the same time, it creates a geometrically-growing future consumption for both retired and working-age population.
The only remaining question is whether the real rate of return would compensate the consumption loss of working-age population and, hence, increase the stock of future consumption to all generations. According to Feldstein and Liebman (2001), assuming 6.5 percent inflation-adjusted rate of return, the payroll cost of fully-funded pension system would represent only 27 percent of the payroll cost incured under PAYG public pension system. Tax rate, required to bear the cost of current stock of pension liabilities is 12.4 percent respectively.
According to Congressional Budget Office, the average real rate of return for large-company stocks between 1926 and 2000 is 7.7 percent, 9.0 percent of small-company stocks and 2.2 percent for long-term Treasury bonds. Feldstein (1997) estimated that PAYG implicit rate of return is 2.6 percent.
Assume an individual wants to maximize the lifetime earnings in the capital market. An individual is offered 2.6 percent implicit return from PAYG system. The individual enters the labor market at certain age, say 25, and intends to retire upon the age of 65. Assume he invests $10.000 annually in the capital market to create retirement annuities upon labor market withdrawal. Assuming the implicit rate of return (2.6 percent), the stock of overall annuity would be 10 times the initial investment in 90 years. Assuming the average long-run real rate of return from large-company stocks (7.7 percent), the the overall annuity would be 10 times the initial stock of investment in 31 years. Therefore, the individual would reach the desired level of lifetime earnings at the age of 56 or 9 years before the targeted retirement age.
I assumed the distribution of lifetime investment portfolio is weighted average of availible asset types: large-company stocks (33 percent), small-company stocks (19 percent), long-term corporate bonds (20 percent), long-term Treasury bonds (20 percent) and 3-month Treasury bills (8 percent). According to the average annual real rates of return in the United States (1926-2000), I calculated the weighted average real rate of return (5.247 percent). Investing $10.000 annually at the age of 25 would buy $100.000 annuity at 5.247 real rate of return in 45 years (the age of 70) compared to 90 years (the age of 115) under the PAYG implicit rate of return (2.6 percent). Of course, the time to buy the annuity would shift alongside the changing composition of portfolio.
In addition, OECD countries should immediately increase the effective retirement age. I believe the solution suggested by Gary Becker is both meaningful but sustainable in reversing the growth of generational debt. Becker (2010) suggested "One simple and attractive rule would be to raise retirement age by an amount that makes the ratio of years spent in retirement to years spent working equal to the ratio that existed at the beginning of the social security system."
When President Roosevelt signed the notorious Social Security Act in 1935, the normal retirement age was 65. However, life expectancy after the age of 65 was significantly lower than is today. In 1940, average life expectancy after 65 in the U.S was 13.7 years. In 2006, it stood at 18.6 years, according to OECD. In 1935, the average life expectancy at birth in the United States was 61.7 years. We assume that individuals in 1935 worked for 35 years and spent 12 years in retirement. The ratio is thus 0.4 (12/ 35=0.34). Today, if individuals retire at the age of 65, they can expect further 18.6 years in retirement. To equalize the ratio to the 1935 level, (18.6/x=0.34), individuals should spend 54.7 years working. The estimate time is an equivalent measure of years required to spend working if PAYG public pension system is left intact. Assuming the individuals enter the labor market at the age of 25, then the expected effective retirement age is the age of 80.
In the long run, PAYG public pension system is unsustainable since demographic parameters do not suffice the assumptions under which the PAYG system is possible without distortions of labor supply incentives. The future of OECD countries will be marked by aging population, lower fertility rates and a growing demographic pressure on public finances. Without bold and decisive pension reform, OECD countries will experience increasing pension deficits and, hence, an explosive growth of generational indebtedness.
Parametric pension reforms are not a substitute for the postponement of paradigmatic pension reform. Thus, implementing the transition to fully-funded pension system essentially requires higher effective retirement age. A comprehensive pension reform cannot be made possible without these measures. At last, but not least, the major challenge in the systematic pension reform in OECD countries to address the burden of global aging, is whether political courage will withstand the pressure of interest groups to maintain the status quo of early retirement incentives. Nonetheless, eliminating early retirement incentives is the essential step towards creating retirement system without perverse incentives to retire too early. Unless political leaders encourage a transition to fully-funded pension system, OECD countries will be unable to withstand the deadly consequences of an enormous generational indebtedness.
Thursday, September 23, 2010
Human capital, labor market and economic growth
The OECD recently published the international comparison of the gap in employment rates between university graduates and workers with secondary education or less (link). There is no single exception to the fact that the employment rate is the highest in the group of individuals with college and university degree. Nonetheless, the comparison of the variation in employment rate in the cross section of OECD countries is very interesting.
Among the OECD countries (link), Iceland enjoys the highest employment rate (94.7 percent) of those with college or university degree followed by Switzerland (93.9 percent), Norway (92 percent) and Denmark (91.4 percent). The lowest employment rate for university graduates in 2008 was in Turkey (81.4 percent), Italy (86.5 percent), Israel (86.6 percent) and Greece (87.2 percent). In contrast, the employment rate for those below the secondary education is the lowest in Slovakia (39 percent), Hungary (47.5 percent), Poland (55 percent) and Czech Republic (57.4 percent).
The persistence of high unemployment rate for those below the secondary education degree is a broad outline of the findings from the course of labor economics. The human capital, defined as the stock of years of education per capita, is highly positively correlated with career earnings. The evolution of human capital across the countries has been a subject of debate on economic growth. The empirical study by Robert Barro and Jong-Wha Lee (link) has shown that, for instance, upper secondary school attendence by males has a significant long-term impact on the economic growth. The level of education, sustained by the years of schooling, is not a sole determinant of economic growth in the international perspective. Although, the economic growth is strongly positively correlated with the average years of schooling, the relationship is less powerful considering different parameters of the educational attainment. In the Barro-Lee dataset (link), there is a significant variation between the share of female population that enrolled in a tertiary education and the share of female that completed the tertiary degree. The difference is significant not only in the cross section but also in the country-based time series.
By far the highest tertiary degree completion rate for female has been present in Australia, Canada, Ireland, New Zealand and the United States. Among other countries, the completion rate of Iceland and the Netherlands has been significantly higher compared to the countries of the Continental and Mediterranean Europe. The rate of return to an additional year of schooling significantly differed across countries and across the level of education. For instance, Barro and Lee estimated that the rate of return is the highest at the tertiary level (17.9 percent per annum) compared to the secondary level (10 percent) while the rate of return from an additional year of schooling at the primary level is statistically insignificant from zero. The picture shows the regional variation in the average rate of return from an additional year of schooling.
The creation of human capital is essential to higher economic growth. Ultimately, the investment in human capital is the essential means of higher standard of living in poor countries. An interesting theoretical question is what could account for a divergence across the countries? Considering the relevant economic theory as well as scholarly contributions to the theory and empirics of economic growth, there are several factors that explain the significance of divergence in the rate of return from an additional year of education.
First, the impact of behavioral patterns on education and labor market decisions explains a pretty large part of the difference between the effect of education and labor market structure on the rate of return from schooling. Although the field of behavioral economics (link) is still a largely evolving discipline within the economics, the existing empirical studies of the effects of institutional variables on education outcome try to capture these effects by different proxies such as the estimates of political freedom, the rule of law and civil liberties. The changes in the return to education may be related to these factors since the relative worth of education in regions such as Sub-Saharan Africa and Latin America may incur high opportunity cost given the payoff from predatory behavior or working in the informal sector of the economy.
Second, general and firm-specific human capital investment, the increase in college premium and the enormous increase in female labor force participation help explain high rate of return from an additional year of schooling in advanced countries and East Asia. In particular, East Asian tigers were able to sustain high economic growth rates partly because of well-trained and educated labor force able to use the modern technologies. The resulting outcome of the Asian economic miracles has been a steady growth in output per worker and a gradual convergence of wage rates in South Korea and Japan to the level of U.S. According to Kevin Murphy and Finis Welch (link), the premium of getting a college education in the U.S in 1980s was 67 percent. The growth in college and university attendence rates is largely explained by the robust increase in tertiary education premium.
And third, greater labor force participation of women has also led to higher rates of college and university attendence. In spite the persistent male-female pay gap, women have experienced a tremendous increase in lifetime earnings as a consequence of higher rates of college and university attendence. The persistence of the male-female pay gap can be explained by the rewards to education rather than by inherent gender bias. The U.S. Census published the relevant data (link) on the distribution of female earnings. In 2003, the female earnings of high school graduates in the 25-34 age thresold represented 78 percent of average male earnings. The earnings of the same female age thresold with bachelor's degree represented 89 percent of male earnings and 71 percent for those female with master's degree. What accounts for the gender earnings gap across the levels of age and education is the asymmetric self-selection that led to dispersed gender distribution of relative earnings. Men usually self-select into the areas of work requiring a significant amount of risk-taking and rather uncertain payoffs while the female labor market pattern is inclined towards less risk-taking and greater certainty regarding the stability of lifetime earnings.
The data by the U.S. Bureau of Labor Statistics (link) published in 2003, showed that female-to-male earnings ratio in high-paying jobs is the lowest in the field of chief executives where female earnings represented 80 percent of average male earnings in the same field of occupation. On average, the female-to-male earnings ratio declined in low-paying occupations such as cashiers (93 percent), cooks (91 percent), food preparation (93 percent) and hand packaging (101 percent). Contrary to the popular perception, female earnings in the field of computer systems management and legal industry represented 91 percent of average male earnings while the highest ratio in high-paying occupations was recorded in pharmaceutical industry (92 percent).
Indeed, there is a persistent and historically lowest male-female earnings gap. But, as the labor economic theory of human capital predicts, the gender pay difference reflects different cognitive abilities and preferences of occupational selection considering the degree of risk-taking and payoff uncertainty. Even the international test scores (link) confirmed that advantage of female cognitive abilities comprehends in verbal reasoning and reading skills (link) while the cognitive abilities of male are more inclined towards the use of computer technology (link) and mathematics (link).
Even in a cross-country perspective, the gender wage differential persists. The gap, defined as the female-male ratio, ranges from 0.9 in France to 0.7 in Canada. The gender wage differential is a cross section of major economies is shown in the table below.
Source: F.D Blau & L.M Kahn, Gender Differences in Pay, 2000
The set of different institutional characteristics of labor market in different countries could easily complement the productivity growth rates as to explain the evolution of wage differential across countries. Even though wage rates are primarily determined by the productivity growth, the existence of collective bargaining schemes and rigid labor market mechanism determining wage rate and total compensation can add significantly to the enforcement of particular labor market policies affecting gender bias in wage determination. In the United States and other advanced countries, the main cause of the wider gender earnings gap is a significant gap between college education premium and high school premium. In addition, reductions in personal income tax rates furthermore increase the rewards to college education relative to the education levels of high school or less - which, by the empirical evidence, seems to be the main determinant of earnings gap in the labor market of advanced countries.
Among the OECD countries (link), Iceland enjoys the highest employment rate (94.7 percent) of those with college or university degree followed by Switzerland (93.9 percent), Norway (92 percent) and Denmark (91.4 percent). The lowest employment rate for university graduates in 2008 was in Turkey (81.4 percent), Italy (86.5 percent), Israel (86.6 percent) and Greece (87.2 percent). In contrast, the employment rate for those below the secondary education is the lowest in Slovakia (39 percent), Hungary (47.5 percent), Poland (55 percent) and Czech Republic (57.4 percent).
The persistence of high unemployment rate for those below the secondary education degree is a broad outline of the findings from the course of labor economics. The human capital, defined as the stock of years of education per capita, is highly positively correlated with career earnings. The evolution of human capital across the countries has been a subject of debate on economic growth. The empirical study by Robert Barro and Jong-Wha Lee (link) has shown that, for instance, upper secondary school attendence by males has a significant long-term impact on the economic growth. The level of education, sustained by the years of schooling, is not a sole determinant of economic growth in the international perspective. Although, the economic growth is strongly positively correlated with the average years of schooling, the relationship is less powerful considering different parameters of the educational attainment. In the Barro-Lee dataset (link), there is a significant variation between the share of female population that enrolled in a tertiary education and the share of female that completed the tertiary degree. The difference is significant not only in the cross section but also in the country-based time series.
By far the highest tertiary degree completion rate for female has been present in Australia, Canada, Ireland, New Zealand and the United States. Among other countries, the completion rate of Iceland and the Netherlands has been significantly higher compared to the countries of the Continental and Mediterranean Europe. The rate of return to an additional year of schooling significantly differed across countries and across the level of education. For instance, Barro and Lee estimated that the rate of return is the highest at the tertiary level (17.9 percent per annum) compared to the secondary level (10 percent) while the rate of return from an additional year of schooling at the primary level is statistically insignificant from zero. The picture shows the regional variation in the average rate of return from an additional year of schooling.
Rate of return from an additional year of schooling across the world
The creation of human capital is essential to higher economic growth. Ultimately, the investment in human capital is the essential means of higher standard of living in poor countries. An interesting theoretical question is what could account for a divergence across the countries? Considering the relevant economic theory as well as scholarly contributions to the theory and empirics of economic growth, there are several factors that explain the significance of divergence in the rate of return from an additional year of education.
First, the impact of behavioral patterns on education and labor market decisions explains a pretty large part of the difference between the effect of education and labor market structure on the rate of return from schooling. Although the field of behavioral economics (link) is still a largely evolving discipline within the economics, the existing empirical studies of the effects of institutional variables on education outcome try to capture these effects by different proxies such as the estimates of political freedom, the rule of law and civil liberties. The changes in the return to education may be related to these factors since the relative worth of education in regions such as Sub-Saharan Africa and Latin America may incur high opportunity cost given the payoff from predatory behavior or working in the informal sector of the economy.
Second, general and firm-specific human capital investment, the increase in college premium and the enormous increase in female labor force participation help explain high rate of return from an additional year of schooling in advanced countries and East Asia. In particular, East Asian tigers were able to sustain high economic growth rates partly because of well-trained and educated labor force able to use the modern technologies. The resulting outcome of the Asian economic miracles has been a steady growth in output per worker and a gradual convergence of wage rates in South Korea and Japan to the level of U.S. According to Kevin Murphy and Finis Welch (link), the premium of getting a college education in the U.S in 1980s was 67 percent. The growth in college and university attendence rates is largely explained by the robust increase in tertiary education premium.
And third, greater labor force participation of women has also led to higher rates of college and university attendence. In spite the persistent male-female pay gap, women have experienced a tremendous increase in lifetime earnings as a consequence of higher rates of college and university attendence. The persistence of the male-female pay gap can be explained by the rewards to education rather than by inherent gender bias. The U.S. Census published the relevant data (link) on the distribution of female earnings. In 2003, the female earnings of high school graduates in the 25-34 age thresold represented 78 percent of average male earnings. The earnings of the same female age thresold with bachelor's degree represented 89 percent of male earnings and 71 percent for those female with master's degree. What accounts for the gender earnings gap across the levels of age and education is the asymmetric self-selection that led to dispersed gender distribution of relative earnings. Men usually self-select into the areas of work requiring a significant amount of risk-taking and rather uncertain payoffs while the female labor market pattern is inclined towards less risk-taking and greater certainty regarding the stability of lifetime earnings.
The data by the U.S. Bureau of Labor Statistics (link) published in 2003, showed that female-to-male earnings ratio in high-paying jobs is the lowest in the field of chief executives where female earnings represented 80 percent of average male earnings in the same field of occupation. On average, the female-to-male earnings ratio declined in low-paying occupations such as cashiers (93 percent), cooks (91 percent), food preparation (93 percent) and hand packaging (101 percent). Contrary to the popular perception, female earnings in the field of computer systems management and legal industry represented 91 percent of average male earnings while the highest ratio in high-paying occupations was recorded in pharmaceutical industry (92 percent).
Indeed, there is a persistent and historically lowest male-female earnings gap. But, as the labor economic theory of human capital predicts, the gender pay difference reflects different cognitive abilities and preferences of occupational selection considering the degree of risk-taking and payoff uncertainty. Even the international test scores (link) confirmed that advantage of female cognitive abilities comprehends in verbal reasoning and reading skills (link) while the cognitive abilities of male are more inclined towards the use of computer technology (link) and mathematics (link).
Even in a cross-country perspective, the gender wage differential persists. The gap, defined as the female-male ratio, ranges from 0.9 in France to 0.7 in Canada. The gender wage differential is a cross section of major economies is shown in the table below.
The Gender Earnings Gap Across Countries
Source: F.D Blau & L.M Kahn, Gender Differences in Pay, 2000
The set of different institutional characteristics of labor market in different countries could easily complement the productivity growth rates as to explain the evolution of wage differential across countries. Even though wage rates are primarily determined by the productivity growth, the existence of collective bargaining schemes and rigid labor market mechanism determining wage rate and total compensation can add significantly to the enforcement of particular labor market policies affecting gender bias in wage determination. In the United States and other advanced countries, the main cause of the wider gender earnings gap is a significant gap between college education premium and high school premium. In addition, reductions in personal income tax rates furthermore increase the rewards to college education relative to the education levels of high school or less - which, by the empirical evidence, seems to be the main determinant of earnings gap in the labor market of advanced countries.
Friday, September 10, 2010
EARNINGS AND EDUCATION: A SURVEY
In 2009, the median weekly earnings of workers with bachelor's degrees were $1,137. This amount is 1.8 times the average amount earned by those with only a high school diploma, and 2.5 times the earnings of high school dropouts (link).
CHINA'S GROWTH MODEL
According to some preliminary estimates (link), China's trade balance is on the course for a significant surplus this year. IMF's annual forecast of current account balance predicted China's trade surplus at $334 billion in 2010 or roughly 6.2 percent of China's GDP. The IMF's medium-term forecast suggests a growing trade surplus by 2015 when the surplus is estimated at a little more than 8 percent of GDP.
Recently, Dani Rodrik questioned (link) the persistence of China's mercantilism based on persistently low exchange rate. The partial fixation of the exchange rate then stimulates export-led growth model and, consequently, results in a large trade surplus which translates into foreign exchange reserves, thus enabling China's central bank to foster exchange rate intervention to defended the targeted yuan exchange rate against the U.S dollar. The implications of China's growth model extend beyond the scope of effects on country's economic growth, investment and current account balance. China's export-led growth model has tremendously affected the macroeconomic performance of developing nations. The exports of developing nations in the European, Japanese and U.S markets basically substitute, not complement, China's exports to the markets of advanced countries. The persistent lack of the appreciation of renmimbi thus forced the economic policymakers of other developing nations to either adopt the same model of exchange rate intervention or lose the export share in developing countries. This intuition is underlined by the theoretical and empirical support.
In 2007, Hausmann, Hwang and Rodrik demonstated (link) that the pattern of specialization by developing countries predicts the subsequent economic growth, suggesting that the share of exports in advanced countries is highly positively correlated with the rates of economic growth. If China shifted the main source of economic growth from export-led model to domestic consumption, the renmimbi would have to appreciate considerably. Contrary to the assertion that China's exchange rate undervaluation hampers the economic growth, industrialization and development prospects of developing nations, the OECD recently stated that developing countries would be hurt significantly if the renmimbi exchange rate were allowed to appreciate. There is also an empirical support for the particular assertion. The OECD recently estimated (link) that, if China's output grew by 1 percentage point, the output of developing countries would decrease by 0.3 percentage point.
The empirics supports the argument I mentioned earlier - China's exchange rate misalignment inevitably hinders the growth prospects and industrialization of developing countries. The essential question in the course of economic development is what is the best model of growth for developing countries to boost industrialization and development frontiers.
One possibility is the so called surplus model. Historically, growth models of low-income countries were primarily based on exporting natural resources to the rest of the world. Countries such as oil-rich gulf states, Botswana and Argentina became wealthy. Such growth model heavily depends on export demand in other countries. The most notable failure of this growth model is that it doesn't encourage the diversification of economic activity. Thus, countries such as Libya have sustained relatively high levels of GDP but, at the same time, rather depressing domestic indicators. For instance, Libya's GDP per capita is at almost the same level as Chile's GDP per capita, but Libya's unemployment rate is 30 percent - almost three times the average unemployment rate in countries with the same level of GDP per capita. When foreign demand deteriorates, these countries experience the Dutch disease - an overheating economic activity and overvalued exchange rates that discourage investment, entrepreneurship and typically result in higher unemployment rates.
Industrialization and economic development mostly depend on domestic structural change based on the adopting the institutions of macroeconomic stabilization and the rule of law. China's exchange rate policy of renmimbi undervaluation is a failed temporary growth model that is set on the unsustainable course. Without shifting the major engine of growth from export-boosting exchange rate undervaluation to consumption-based growth, Chinese economy will no longer be able to sustain high productivity growth rates. Letting the renmimbi appreciate by free floating could significantly boost the potential for institutional change in China and other developing nations. Therefore, the systemic abuse of macroeconomic policy by exchange rate undervaluation would no longer be feasible and the costs of failed exchange rate regime for developing countries would diminish substantially.
Recently, Dani Rodrik questioned (link) the persistence of China's mercantilism based on persistently low exchange rate. The partial fixation of the exchange rate then stimulates export-led growth model and, consequently, results in a large trade surplus which translates into foreign exchange reserves, thus enabling China's central bank to foster exchange rate intervention to defended the targeted yuan exchange rate against the U.S dollar. The implications of China's growth model extend beyond the scope of effects on country's economic growth, investment and current account balance. China's export-led growth model has tremendously affected the macroeconomic performance of developing nations. The exports of developing nations in the European, Japanese and U.S markets basically substitute, not complement, China's exports to the markets of advanced countries. The persistent lack of the appreciation of renmimbi thus forced the economic policymakers of other developing nations to either adopt the same model of exchange rate intervention or lose the export share in developing countries. This intuition is underlined by the theoretical and empirical support.
In 2007, Hausmann, Hwang and Rodrik demonstated (link) that the pattern of specialization by developing countries predicts the subsequent economic growth, suggesting that the share of exports in advanced countries is highly positively correlated with the rates of economic growth. If China shifted the main source of economic growth from export-led model to domestic consumption, the renmimbi would have to appreciate considerably. Contrary to the assertion that China's exchange rate undervaluation hampers the economic growth, industrialization and development prospects of developing nations, the OECD recently stated that developing countries would be hurt significantly if the renmimbi exchange rate were allowed to appreciate. There is also an empirical support for the particular assertion. The OECD recently estimated (link) that, if China's output grew by 1 percentage point, the output of developing countries would decrease by 0.3 percentage point.
The empirics supports the argument I mentioned earlier - China's exchange rate misalignment inevitably hinders the growth prospects and industrialization of developing countries. The essential question in the course of economic development is what is the best model of growth for developing countries to boost industrialization and development frontiers.
One possibility is the so called surplus model. Historically, growth models of low-income countries were primarily based on exporting natural resources to the rest of the world. Countries such as oil-rich gulf states, Botswana and Argentina became wealthy. Such growth model heavily depends on export demand in other countries. The most notable failure of this growth model is that it doesn't encourage the diversification of economic activity. Thus, countries such as Libya have sustained relatively high levels of GDP but, at the same time, rather depressing domestic indicators. For instance, Libya's GDP per capita is at almost the same level as Chile's GDP per capita, but Libya's unemployment rate is 30 percent - almost three times the average unemployment rate in countries with the same level of GDP per capita. When foreign demand deteriorates, these countries experience the Dutch disease - an overheating economic activity and overvalued exchange rates that discourage investment, entrepreneurship and typically result in higher unemployment rates.
Industrialization and economic development mostly depend on domestic structural change based on the adopting the institutions of macroeconomic stabilization and the rule of law. China's exchange rate policy of renmimbi undervaluation is a failed temporary growth model that is set on the unsustainable course. Without shifting the major engine of growth from export-boosting exchange rate undervaluation to consumption-based growth, Chinese economy will no longer be able to sustain high productivity growth rates. Letting the renmimbi appreciate by free floating could significantly boost the potential for institutional change in China and other developing nations. Therefore, the systemic abuse of macroeconomic policy by exchange rate undervaluation would no longer be feasible and the costs of failed exchange rate regime for developing countries would diminish substantially.
Monday, September 6, 2010
PRODUCTIVITY GROWTH IN BRAZIL
Carlos Pereira of the Brookings Institution (link) has reviewed the dismal productivity growth and the consequent macroeconomic indicators in Brazil in the last decade.
"Although there are several expenditures in this category, the one that stands out high above all others is outlays for social security and pensions. Practically one-third of the federal budget is devoted to these expenditures, whereas expenditures in investments were less than 6 percent in 2003. Pensions in Brazil since the 1988 constitution have been notably generous, especially in the civil service. A new group of non-contributing rural pensions was added, contributing to systematic deficits. With about 11.7 percent of GDP, Brazil has one of the highest social security expenditures in the world, especially considering that the Brazilian population is much younger than that of most countries with similar levels of expenditure."
"Although there are several expenditures in this category, the one that stands out high above all others is outlays for social security and pensions. Practically one-third of the federal budget is devoted to these expenditures, whereas expenditures in investments were less than 6 percent in 2003. Pensions in Brazil since the 1988 constitution have been notably generous, especially in the civil service. A new group of non-contributing rural pensions was added, contributing to systematic deficits. With about 11.7 percent of GDP, Brazil has one of the highest social security expenditures in the world, especially considering that the Brazilian population is much younger than that of most countries with similar levels of expenditure."
Sunday, September 5, 2010
SKILLED IMMIGRATION AND INNOVATION
A recent paper by Jennifer Hunt (link) finds that the increase in foreign-born graduates strongly contributes to the innovation in the United States:
"In this paper I have demonstrated the important boost to innovation per capita provided by skilled immigration to the United States in 1950-2000. A calculation of the effect of immigration in the 1990-2000 period puts the magnitudes of the effects in context.
"In this paper I have demonstrated the important boost to innovation per capita provided by skilled immigration to the United States in 1950-2000. A calculation of the effect of immigration in the 1990-2000 period puts the magnitudes of the effects in context.
The 1990-2000 increase from 2.2% to 3.5% in the share of the population composed of immigrant college graduates increased patenting by at least 81:3 = 10:4%, and perhaps by as much as 18%. The increase in the share of post-college immigrants from 0.9% to 1.6% increased patenting by at least 10.5% and perhaps by as much as 24%. The increase from 0.30% to 0.55% in the share of workers who are immigrant scientists and engineers increased patenting by at least 13% but probably by less than 23%.
While I find evidence for the crowding-out of natives in the short run, in the long run there is evidence for the reverse: that skilled natives are attracted to states or occupations with skilled immigrants. The results hint that skilled immigrants innovate more than their native counterparts, especially if they are scientists or engineers. If correct, the result could reflect higher education of immigrants within skill categories, or positive selection of immigrants in terms of ability to innovate. However, the effect of natives is not as well identified econometrically as the effect of immigrants."
Thanks to New Economist (link) for the pointer!
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