An individual who decides to save for retirement has a choice between a number of different savings vehicles: stocks, bonds, real estate, etc. What are the choices when we aggregate up to the economy as a whole?
I write this post in response to an email from someone who is knowledgeable about the savings vehicle question at the individual level, but was trying to aggregate up to the macro level, knew that aggregation was problematic (the paradox of thrift, for example), had read a couple of my old posts, and asked for my assistance.
The national income accounting identity S=I+G-T+NX (saving equals investment + government deficit plus net exports) may be useful, but should not rule our thoughts. Because the definition of "saving" that it uses may not be the only useful definition.
To be semi-concrete: suppose the government decides to encourage people to save more for their retirement. Where can the extra savings go?
Let's start with S=I+G-T+NX, and see how far we get.
1. NX. Increased net exports (reduced net imports). Lend more to foreigners (borrow less from foreigners). If I save more, by consuming less, or by earning a higher income, I lend a larger part of my income to everyone else, and increase my "net exports" to everyone else. Everyone else is a foreign country, in the individual experiment. A "small" open economy, which has negligible effect on the rest of the world, is just like an individual. We don't ask what the "foreigners" will do with our savings. But this isn't really macro (apologies to open economy macroeconomists). We can't all increase our net exports.
2. I. Increased investment. "Investment", like "saving", has a particular meaning in national income accounting. It means "producing more means of production". We all consume less and invest more, which means we produce fewer consumption goods and more investment goods. Factories and machines are the archetype. But we should include investment in software, research and development, and human capital too. And also consumer durables, like houses and cars. A house is just a machine that produces a flow of output services; we call those services "somewhere to live".
3. G-T. Individuals can save more by consuming less or earning more, and lend more to the government, just like we can lend more to foreigners. And just as we don't ask what foreigners will do with our savings, we don't ask what the government will do with our savings. But this is clearly problematic. Government is not like a foreigner. We own the government (or the government owns us). Lending to the government is like lending to ourselves.
The S=I+G-T+NX identity is useful for some purposes, but is not the most useful for this purpose. The question of saving for retirement begs for an overlapping generations (OLG) perspective, and that perspective is entirely missing from S=I+G-T+NX, because it aggregates across all generations alive in any given year.
Let's start again from the beginning.
Young people are working and earning an income from producing goods. They want to retire (stop working) when they are old, and yet continue to consume goods. How can they make this happen?
Start with a very simple OLG model: land and labour produce wheat, which can be stored. In this model, there are two ways a young individual can save for his retirement: buy land that he can sell for wheat when he is retired; store wheat that he can consume when he is retired.
Though terribly "unrealistic", this very simple model is much more useful than the S=I+G-T+NX accounting identity.
1. Buy Land.
Each individual who wants to save more by buying more land can do so. But they can't all do this. What happens if all individuals decide to double the value of their savings in terms of wheat? The price of land doubles. Does this doubling of the price of land give them a better standard of living when they retire and sell their land to the next generation? Yes, but only if the next generation also doubles its saving too. The value of each cohort's land when it retires depends not on how much it saves, but on how much the next cohort saves.
The land in my simple model works exactly like an unfunded PAYGO pension plan. If the young in cohort B double the value of their savings in land, it is the old in cohort A who benefit, by selling land at twice what they paid for it, and the old in cohort B only eat more wheat if the young in cohort C double the value of their saving in land too. If one future cohort "breaks the chain", and does not double the value of its saving in land, the old in the preceding cohort are worse off than they would have been otherwise; they consume less wheat when young, by paying double the price to buy the land, but consume no more wheat when old than they would have without doubling their saving.
The land in my simple model also works exactly like government debt. If the government cuts taxes (or increases transfer payments) for the current cohort, that cohort is better off. It is exactly as if the government gives bonds to cohort A, as a freebie, and cohort A, when it is old, sells those bonds to the young in cohort B in exchange for wheat. Cohort A eats more wheat. Provided the government rolls over the debt plus interest, so that cohort B pays no more taxes than before, cohort B is no worse off (and may be better off). But if some future government "breaks the chain", by increasing taxes to pay down the debt, or simply pay interest on the debt (and it may be forced to break the chain to prevent the debt/GDP ratio growing without limit so the bonds cannot be rolled over) the cohort that pays the highr taxes is worse off.
The simplest way to think about PAYGO pension plans and government debt is to ask instead what would happen if the government issued bonds and bought land. The rent on the land pays the interest on the bonds. A compulsory PAYGO pension plan is like the government buying land on your behalf.
Don't take "land" too literally. Saving by buying antique furniture, old houses, or old paintings, is also just like saving by buying land.
2. Store wheat.
Buying land does not count as "saving" and "investment" in national income accounting, even though it may push up the value of land, and provide a way for everyone to have a better standard of living in retirement (provided no future cohort "breaks the chain"). Storing wheat does count as saving and investment, because wheat put into store is a newly-produced good that is not being consumed. Storing wheat is a form of investment that has a zero real rate of return. (Or negative, if storeage is costly, or if some stored wheat is lost to rats.)
Investment in machinery is a hybrid between storing wheat and buying land.
When we divert current production away from consumption towards investment, we consume less wheat today, but can consume more wheat in future. But investment in machinery may (or may not) provide a higher rate of return than storing wheat.
When the current cohort buys machines, it can sell its stock of those machines to the next cohort to fund its retirement, just like land. Provided the next cohort does not "break the chain", and wants to save too, otherwise they won't pay anything for the machines.
Demographics will matter. Take the extreme case, where there is no next generation, and the population dies out, because nobody has any kids. Buying land won't work, because there is no next generation to sell it to. And if the machines require labour to operate, that won't work either. The only feasible investment vehicles are: storing wheat; building robots (labour-saving capital goods).