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Journal of Monetary Economics 54 (2007) 199–204

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Discussion

Comment on ‘‘Global demographic trends and socialsecurity reform’’ by Orazio Attanasio, Sagiri Kitao,

and Giovanni Violante

Deborah Lucas�

Northwestern University and NBER, USA

Received 13 November 2006; received in revised form 21 November 2006; accepted 6 December 2006

Available online 27 December 2006

1. Introduction

With the rapid aging of the population and accompanying growth in fiscal deficits, thequestion of the sustainability of current social security systems in developed countries isbeing debated with increasing urgency. This paper makes a significant contribution to thedebate, providing a carefully calibrated model to compare the macro-economic andwelfare implications of alternative policies in a world with integrated capital markets andasynchronous population and productivity growth, versus in a closed market economy.The analysis is thoughtful, thorough and readable, making the job of a discussant bothmore enjoyable and more challenging.

The main insight of the paper—that the asynchronous demographic transition and othertrend differences between the developed north and less developed south serve to dampenthe effects of aging in the north—is an important one. The time path of wages, capital,output and overall welfare is more favorable for developed countries than would bepredicted in a similar closed economy analysis under most policy alternatives. Theseimplications are intuitively persuasive and appear robust, since adding more flexibility toan economy tends to reduce the impact of shocks. More broadly, the analysis providesan alternative perspective to existing models in the literature that predict severe

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ARTICLE IN PRESSD. Lucas / Journal of Monetary Economics 54 (2007) 199–204200

macroeconomic consequences of maintaining pay-go social security in the face ofdemographic change.The authors also use the model to compare the implications of alternative approaches to

bringing the retirement system into balance, including raising the retirement age, cuttingbenefits, raising taxes on capital, consumption, and or wages, and increasing debtfinancing. The model is also used to study a transition from a pay-go to a fully fundedsystem, using recognition bonds to mitigate the distributional effects. Such policycomparisons must be interpreted with more caution for several reasons: a macroeconomicanalysis cannot capture important cross-sectional welfare consequences that are likely firstorder for social security reform; the social security system is assumed to cause distortionsbut to provide no off-setting benefits; the conclusions are quite sensitive to assumptionsabout poorly measured parameters such as long-run labor supply and interest rateelasticities; and only very stylized policy alternatives are considered. Nevertheless, themodel provides a useful framework in which to assess the relative efficiency anddistributional consequences of various policy alternatives.The rest of this discussion is organized as follows: Section 2 recaps the model, and

summarizes the intuition behind the main results. Section 3 revisits some of the criticalassumptions, and considers how other factors not currently incorporated might affect theinterpretation of the results.

2. Model recap

The backbone of the analysis is a deterministic, overlapping generations, two-countrymacroeconomic model, with one country representing the developed north and the otherthe less-developed south. The regions are assumed to be similar in many respects: People inboth areas have standard CRRA preferences over consumption, with wealth effectsdominating substitution effects. Output flows from a standard Cobb–Douglas productionfunction with exogenous productivity growth. Labor supply is inelastic, although thesensitivity analysis contemplates an extension with a labor leisure choice. The governmentfinances social security and other expenditures by levying taxes on capital income,consumption and/or labor income, or by raising risk-free government debt, satisfying itsbudget constraint. Wages clear the labor markets in each region, and interest rates clear theworld capital market, or local capital markets in closed economy implementations.A major contribution of the paper is the model calibration. For each region, information

on projected fertility, mortality, productivity, and labor supply is collected from a widevariety of international sources, and synthesized to generate the exogenous paths of laborsupply, the age structure of the population, and productivity that together drive the results.Government policy in each region is also exogenous.Several major differences between the two regions contribute to integrated capital

market predictions for the north that are quite different than those when a similarlycalibrated closed economy is considered. With regard to demography, the south starts withmuch higher fertility rates. The southern fertility rate then slows rapidly and eventuallyconverges to the long-run rate in the north, which is slightly above the replacement rate.Initially the northern population is older, with life expectance increasing more slowly thanin the shorter-lived south. Turning to production, the developed world is initially at aproductivity advantage. TFP grows in both regions, with southern rates eventuallyconverging to the constant northern growth rate. Labor force participation also is initially

ARTICLE IN PRESSD. Lucas / Journal of Monetary Economics 54 (2007) 199–204 201

higher in the north, but converges over time as southern female labor force participationreaches northern levels. The net effect of these relative levels and trends is that the southhas a larger, younger, less productive workforce over the next 50–100 years, after whichmost rates have converged. The south for many years also has a lower old age dependencyratio, and a much lower tax burden. The lower taxes can be largely attributed to theabsence of a pay-go social security system.

The supply of labor is predetermined in both regions, making capital the criticalendogenous variable underlying the differences between integrated capital market andclosed economy results. In the integrated case, capital flows across regions to equate themarginal product of capital, thereby enhancing overall production efficiency. During thedemographic transition, capital flows to the north for at least two reasons: labor is moreproductive, and southerners have a higher propensity to save since they lack a socialsecurity system. Hence, foreign capital helps the north weather the long period of relativelyhigh retirement and dependency rates. The growing and more efficiently allocated supplyof capital drives down its marginal product, implying a steeply declining, and eventuallylower, path of interest rates in the open economy case. Further, the relative decline in thenorthern workforce increases the marginal product of its labor force. The concomitantincrease in the northern wage rate is a further effect offsetting some of the burden of thehigh dependency ratio.

The generally more favorable economic conditions in the north with integrated capitalmarkets occur under most of the policy regimes considered. Still, macroeconomic andwelfare outcomes differ with the policy under consideration. If benefits are maintained atcurrent levels, either taxes must increase, or debt can be used along with later, larger, taxincreases. Whether a particular cohort prefers an immediate tax increase or debt financingnaturally depends when they are born, with debt benefiting older workers and tax increasesimproving the welfare of younger workers and future generations. Benefit cuts in the formof a lower replacement rate or postponing the retirement age also help younger workers atthe expense of older workers. Since pay-go social security is assumed to provide no specialbenefits (such as improved risk sharing within and across generations), but it depressessavings rates and necessitates distortionary taxes or government debt, overall welfare tendsto be improved, somewhat artificially, by a transition to a pre-funded system or by otherpolicies that effectively reduce the size of the system.

A commendable feature of the analysis is extensive sensitivity analysis. The authorsconsider many possibilities, including variations in the inter-temporal elasticity ofsubstitution, the speed of TFP growth and whether convergence occurs in growth ratesor levels, population dynamics, the effect of capital market frictions, and elastic laborsupply. They find that there is little sensitivity of the main results to many of thesealternatives. Major changes such as excluding China and India from the world capitalmarket, however, do significantly alter the model’s quantitative predictions.

3. Assumptions and sensitivities revisited

Incorporating realistic, and hence complex and non-stationary, transition paths for thedriving variables complicates solution of the model, and makes stochastic analysisextremely difficult. Consequently, the authors solve the model assuming certainty andperfect foresight. While the simplification may be analytically necessary, it is important inkeep in mind the enormous uncertainty associated with such predictions, especially over

ARTICLE IN PRESSD. Lucas / Journal of Monetary Economics 54 (2007) 199–204202

the long time horizons considered. As an example of the uncertainty, Fig. 1 shows the 90%confidence interval associated with U.S. social security benefits as a share of GDP,generated by a related but stochastic model developed by the Congressional Budget Office.Although many aspects of the model are consistent with historical data and trends,

others appear to be less so. One problematic set of predictions is for the real interest rate,which as the authors note, is better interpreted as the marginal product of capital. In theopen economy, the real rate is predicted to fall from 8% to less then 3% over 100 years.Historically real rates appear to have varied by much less than that, despite major changesin the social, economic and policy environment.The predicted path of interest rates is affected by many aspects of the model including

the elasticity implied by the utility function, life expectancy, life cycle effects, and taxes andtransfers. As noted in the paper, other factors also thought to affect interest rates are notincluded, most notably, uncertainty. It seems likely that the excessive sensitivity of thepredicted interest rate to the time path of model parameters is partly an artifact of theperfect foresight assumption. That is, the savings rate is likely more sensitive to the knownfuture course of the economy than it would be were policy, demographics, and economicconditions stochastic. With uncertainty, a precautionary demand would decrease thesensitivity of aggregate savings to current and anticipated future conditions.Another assumption that affects the southern saving rate, and hence the equilibrium

interest rate, etc., is that policy remains unchanged over time in the south. As thoseeconomies develop and establish better social institutions for risk-sharing, the propensityto save may decrease, increasing the long-run world interest rate relative to the predictedlevel. Arguably, the current conditions that exist in the south are similar to those thatmotivated adoption of social security in the north many decades earlier: rapidindustrialization, increased life expectancy, growing wealth, and increased labor mobility.In fact there is considerable heterogeneity in savings rates across southern economies nowand in the past, suggesting the potentially large effect of current and future institutionalchanges to affect the future evolution of saving behavior (see Fig. 2).A related question is whether the salutary effect on savings of transiting from a pay-go

to a pre-funded system would be predicted to be as large in a model with uncertainty? Ifpeople anticipate the benefit cuts or future tax increases needed to balance the system,northern savings rates should be relatively higher before the transition than predicted here.

Fig. 1. Uncertainty and time horizon. Projected social security benefits under unchanged legislation in the United

States. Projections based on 500 stochastic simulations around central demographic and economic assumptions,

80 percent range from the 10th to the 90th percentile. For details on the methodology, see Congressional Budget

Office (2001). Source: Congressional Budget Office (2004).

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Fig. 2. Saving and investment in the emerging market and oil producing economies. The sharp drop in investment

in east Asia and increase in saving in the oil-producing countries are two other important developments behind

the recent global current account imbalances. Sources: OECO Analytical Database; World Bank, World

Development indicators and MF staff calculations.

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Several aspects of labor supply also deserve further consideration, including the assumedpattern of labor force participation, and the inelastic labor supply. Perhaps a minor pointis that male labor force participation is taken to be 100% in both regions. In fact, malelabor force participation in prime working years has fallen significantly in the U.S. over thelast quarter century, and stands at around 88% for men aged 45–54. This decline is thesource of policy concern, the fear being that if the trend continue dependency ratios will beeven higher than currently forecast.

The assumption of a completely inelastic labor supply in the base case casts doubt on thegenerality of the finding that a payroll tax is less distorting than other policy alternativesfor balancing the system. In response to this critique, the authors developed a variant ofthe model with endogenous labor supply that is incorporated into the sensitivity analysis.

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The income and substitution effects of higher taxes tend to cancel out in their specification,leading the authors to conclude that taxes may have relatively minor effects on laborsupply. Nevertheless, there is an on-going debate about the long-run effects of taxes onlabor supply, with some arguing that although labor supply is inelastic in the short-run, itmay be much more elastic in the long run, for instance as evidenced by the Europeanexperience. When the payroll tax is used to balance the social security system in this model,the resulting tax rates are very high, suggesting that labor supply effects still should beconsidered more carefully in comparing policy options.A more general observation about labor supply is that like capital mobility, flexible

labor supply tends to offset the pressures of an aging population. It seems reasonable toexpect that taking that flexibility into account, either by including international labor flowsin an extended model, or by incorporating a more complete labor supply response to policyand demographic changes, would strengthen the conclusion that the demographictransition may have lower costs than suggested by some past analyses. It is a strengthof this modeling approach that such experiments could be incorporated and quantified,and I look forward to following the results of this research agenda.