Social Security: National Policies with International Implications

Abstract

Social security policies within individual countries are determined independently by national governments, but the resulting outcome is inefficient compared with what would result from the international co-ordination of policies. This is because national social security policies produce international externalities via their effects on world interest rates. An illustrative example suggests that the gains from co-ordination are potentially significant. Virtually all countries operate social security (or redistributive) policies. Each chooses policies independently, and to my knowledge no-one, either in a policymaking context or in the large literature on international policy co-ordination, has suggested that such decisions would benefit from international coordination.1 However, a simple argument suggests that independent national social security policies are inefficient: more specifically, in the long run national governments make policy decisions which are too egalitarian. This holds provided that social security lowers national saving. In this case, each national government faces a trade-off between income redistribution and national saving, and can be assumed to locate at the nationally optimal point on this trade-off, taking as given the world interest rate. The latter is clearly not independent of the combined effect of all countries' policies, however: if all countries expand social security, the resulting fall in world saving will raise the world interest rate, with adverse consequences for each national economy. Each country rationally ignores its own (small) contribution to the global outcome. If this international externality were internalised by co-ordination, countries would relocate on the trade-off between income redistribution and national saving. Demonstrating the existence of an externality says nothing about its quantitative significance. I address this with an example which focuses on pay-as-you-go (PAYG) retirement pensions in an economy with a mixture of forward-looking and myopic individuals. The pensions prevent destitution among retired myopes and thus effectively redistribute life time welfare, but they also lower saving because of PAYG financing. For all parameter values considered, international co-ordination of pensions policy decisions generates welfare gains which are larger - for many parameter values substantially larger - than recent estimates of the welfare gains from either the entire elimination of all cyclical fluctuations, or the reduction of inflation and nominal interest rates from suboptimally high to optimal levels. Hence the issues addressed in the paper are quantitatively significant when judged against other frequently-advocated * I am grateful to two anonymous referees for helpful comments on earlier versions; they are not responsible for the present version.