1 Jesus Ferreiro & Felipe Serrano Department of Applied Economics V University of the Basque Country Conference Economic Policies of the New Thinking in Economics St Catharine’s College, Cambridge, United Kingdom Thursday 14 April

2 All economic approaches link the analysis of institutions to the existence of information problems: institutions are a source of information for individuals, and, consequently, an instrument that help them to make decisions. Institutions have a microeconomic nature: they are instruments that help individuals to make decisions in an environment characterized by the existence of information problems. However, not all the economic approaches include the same kind of information problems, and, consequently, the institutions that these approaches consider as necessary to solve the information problems suffered by the individuals are also different. 2

3 Neoclassical paradigm bases the existence of a market-clearing equilibrium outcome on the existence of perfect information. In the short-run this axiom is relaxed to include some information problems: asymmetric information and bounded rationality The kind of institutions that mainstream approach considers as necessary are those that help to solve the problems of asymmetric information and bounded rationality (examples: agencies, independent central banks) Neoclassical-mainstream economics cannot incorporate in its analysis the concept of uncertainty, and, consequently, it cannot incorporate the institutional dimension related to the existence of uncertainty: efficient resources allocation made by the agents, that is, those decisions that lead to a market-clearing equilibrium outcome, can only be adopted in an environment where uncertainty does not exist.

4 To include the existence of uncertainty in the economic analysis, we need a different paradigm, where the concept of equilibrium is different of a market-clearing outcome. The concept of equilibrium involves the idea of the existence of an economic outcome that can be considered as stable, predictable and desirable: it involves stable functional relations among economic variables and stable individual behaviours This existence of this equilibrium is based on the existence of stable expectations in the short and in the long-run. However, the stability of expectations can be reached at any level of economic activity. Therefore, the stability of expectations is a necessary condition but not sufficient to attain a full employment outcome. The stability of expectations and economic outcomes is related to the existence of stable institutions that help individuals to behave in a specific way. Therefore, institutions are a key determinant of the economic activity in market economies. Thus, although institutions have a microeconomic origin, they have macroeconomic implications

5 Macroeconomic implications of social security systems Neoclassical treatment of this social security focuses on its negative impact on private savings, and, consequently on capital accumulation, economic activity and individual welfare. This analysis is coherent in a world of perfect information and a market-clearing equilibrium. However, in an uncertain world the macroeconomic dimension of this institution is different. In a world of uncertainty, higher savings related to higher uncertainty lead to lower economic activity. By reducing long- term uncertainty, social security systems have contributed to a higher and more stable economic activity, and to a higher welfare for individuals, having a clear macroeconomic dimension

6 Economic implications of social security reforms Mainstream economics recommends the replacement of the present systems based on a pay-as-you-go system by funded individual savings accounts. The reason is twofold: the impact of ageing process of the financial sustainability of public pension systems and the negative impact of PAYG systems in the economic activity All pension systems are negatively affected by ageing process. Then, the radical reform of public pension systems would only be justified by the presumed better economic performance generated by the funded pension system. This better performance is only generated in a world with perfect information.

7 The reforms implemented in developed and developing economies introducing mandatory funded pension plans through mandatory defined contribution systems, have suffered the problem that the expected increase in private savings has not happened, what is explained by the agents’ bounded rationality This problem, that might be solved by financial education and a correct regulation, do not solve the problems generated by the existence of uncertainty

8 The existence of uncertainty has two implications in the analysis of the reforms of social security systems: Present resource allocation decisions are subjected to continuous adjustments if expectations are not fulfilled, thus leading to adjustment costs. The best social security system is that one that by minimizing the uncertainty about future minimizes the costs of adaptation to a changing environment In an uncertain world, the presumed macroeconomic effects of the radical reforms in the social security and pensions systems (higher capital accumulation and higher economic activity) are not evident.

9 Conclusions For neoclassical economics the best solution to the problems that ageing processes generate on public pension systems based on a PAYGO system is their (partial or total) replacement by funded systems based on individual accounts. The neoclassical argument that funded pension systems are sheltered from ageing is false. Moreover, the presumed positive effects on economic activity from a radical reform of pension systems depend on a set of assumptions that do not happen in the real world. When we introduce uncertainty the conclusions about the economic impact of these reforms vanish, being highly probable that they have a depressing impact on the economic activity and the individuals’ welfare. Institutions like social security have reduced the uncertainty about future providing beneficiaries with the certainty of income during the retirement period. They have helped to stabilize the working of the aggregate economy and to implement a macroeconomic policy that smooth the short-run economic fluctuations. This does not mean that this system do not face problems: public pension systems need to be reformed when structural changes endangers the fulfilment of the main objective of the system: providing individuals a socially acceptable income.