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Edward Prescott: A prophet regarding Social Security

By Benjamin Che
web posted November 1, 2010

Humorist and political columnist Dave Barry once sarcastically proclaimed "I care about our young people, and I wish them great success, because they are our Hope for the Future, and some day, when my generation retires, they will have to pay us trillions of dollars in social security."    His words reflect the thoughts of 2004 Nobel laureate Edward C. Prescott, in his Wall Street Journal article, "It's Irrational to Save."  In this brief article, Edward C. Prescott argues for "rebuilding" Social Security, citing the lack of incentives to save, the marginal costs of current Social Security, and the inelasticity of the labor supply.

When the Social Security act first came into existence in the early 1900's, the ratio of workers to the elderly was at a stunning 41-to-1.  Prescott sets the groundwork for his case by stating that "Social Security was developed at a time when the number of workers paying into the system greatly outnumbered those who were receiving funds."   Today, this ratio is at 3-to-1.  Prescott examines the marginal costs and benefits of saving and earning for young workers today, concluding that the marginal costs of saving and earning more outweigh the marginal benefits because of this drain for Social Security.  Rationally, these workers ought to work less and save less, for "people are acting rationally when they choose not to save."

The laws of supply and demand in the labor market come into play here.  Prescott believes that the labor supply regarding tax policy is in fact not inelastic and does indeed respond to changes in the tax rates.  This insight makes us reexamine the marginal effects of the governmental fiscal policy of Social Security.  The marginal benefits of not working, of leisure, outweigh the marginal benefits of working and saving.  The lack of incentives to save in regard to fiscal policy in America is one of the reasons Social Security has become such a leech on the national budget today, according to Prescott.

So why exactly is it irrational to save?   According to Prescott, the main reason for the irrationality of personal savings is the fact that the United States economy is becoming more and more socialistic, where incentives for extra work or profit are far and few between.  To support our ever growing budget allocations for social benefits, we have abandoned our core values of self-sufficiency and labor.  As Prescott remarks, "If, for example, somebody knows that they will be cared for in old age ---- even if they don't save a nickel -- then what is their incentive to save that nickel?

How should we then solve the problem?  The author of "It's Irrational to Save" says that rebuilding the Social Security system by establishing a system of mandatory investment accounts for retirement is the key to the issue.  Why mandatory accounts?  As Prescott surmises, "without mandatory savings accounts we will not solve the time inconsistency problem of people under-saving and becoming a welfare burden.  Such a plan would involve graduated monetary input to a retirement program that would offer investment choices to the worker.

Prescott's insight into the effect of tax rates on labor supply and the marginal effects of current policy bear even greater importance and feasibility in the current recession, where Keynesian government injection of money into the economy has not raised the equilibrium of labor supply and demand; instead, we are experiencing record high amounts of unemployment.  The current governmental policy is clearly not working and with projections of federal debt due to accumulated budget deficits rising to record high levels, it's not likely that we will recover anytime soon.  After all, with marginal costs and benefits changing the situation from people being so irrational that they have to be forced to save, to the situation of people being rational by not saving, what is there to offset our growing budget deficits? ESR

©2010,  Benjamin Che

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