Economics 10: the financial life cycle

by George Hatjoullis

Laissez-faire philosophy focuses on the individual. It is all about individual freedom, individual effort, individual choice etc. It treats the fact of inheritance as a parameter of life. Each individual has a genetic inheritance and a social inheritance. Modern society tends to privilege ‘naturally’ gifted people but looks down on those that are socially privileged. However, this is a different philosophical issue. The point of interest is that each individual does not start in the same place and laissez-faire liberals have nothing to say on this issue. Of course, what looks like privilege when one is born may turn into a handicap depending upon the physical and social environment that one grows into. From this perspective perhaps the laissez-faire philosophers have a point. We begin with a genetic and social inheritance that we have no say in and it is up to us to make the best of this inheritance. This seems to be the philosophy that underlies economic theory.

In early phases of development, the child is in learning mode and dependent upon parents. The state will provide some support but it is largely the responsibility of the parents to determine the opportunities a child has. Clearly social status is influential as is the wealth and income of the parents. At some point, the child becomes an adult and responsible for her/his own financial life. The young adult may still benefit from financial transfers from the parental or family unit and will receive some state help or ‘social wage’. The social wage is simply the financial benefits each citizen receives from the state, a kind of negative tax. Apart for the most socially endowed, the young adult begins adult life with little (and increasingly negative) private financial wealth. The young adult must sell labour units in order to generate income. From this income, the young adult must accumulate financial wealth in order to be able to claim the necessary portion of GDP when she/he has no income from the sale of labour units (or employment). In simple terms, the individual begins adult life with typically zero to negative financial wealth, accumulates financial wealth from income (saves) and then uses such wealth to acquire a share of GDP when income from employment is no longer available (unemployment and retirement).

The financial decisions of individuals depend upon many factors. First, and foremost, is disposable income. This is a function of how much the individual can sell her/his labour units (which will have been determined in part by genetic and social inheritance) and the taxation rate. The individual must decide how much of current GDP to claim from income and how much to save as a claim on future GDP. Clearly, the higher the disposable income, the more that is available for saving. An individual earning only sufficient to subsist in poverty is not able to save anything. Such individuals may already be dependent on the social wage (or state benefits if you prefer) and will be so dependent (even more so) if they can no longer sell labour units. Laissez faire philosophers prefer the social wage to be kept to a minimum to avoid the risk of moral hazard. The view is that if the social wage is too high people will simply not work and the wealth creation process will grind to a halt (‘Minimum’ is not simply a matter of level of social wage but also the conditions for receiving it). Now you may grasp the relevance of the preamble about genetic and social inheritance. The moral hazard argument studiously avoids the fact that some people have a head start. The other issue to note comes from the fact (discussed in Economics 8) that productivity growth may make it possible for some to work fewer hours. The moral hazard issue may not be as simply as our laissez-faire philosophers suggest.

Another important factor is the expected physical and working life time of the individual. People on average live longer than they used to do (in the advanced economies at least). Logically one might expect people on average to extend their working lives to compensate. Unfortunately, it is not quite this simple. Living longer does not mean living healthier and health is key to working life. Indeed with the demise of the extended family, living longer means expensive care for longer periods. In short, longer life means a need to save more. It means more private wealth is needed unless the state accepts the increased cost of providing the social wage for longer (pensions, care homes, hospitals etc). Our laissez-faire philosophers have a simple solution; save more. It matters not that people do not start from the same position, or that they have different levels of luck, make better or worse decisions and so on. Individuals must be responsible for their own lives, make their own decisions and accept their lot. The state should minimise the social wage to ensure everyone has an incentive to work hard and make prudent financial and consumption decisions. There is a problem with this view however that was the subject of Economics 8.

The realisation of lengthening mortality rates is relatively recent and has inspired later retirement dates and constant pressure for the population to defer claims on current GDP in favour of the consumption of future GDP. The state has added to this by reducing the social wage and government borrowing (and thus claims on future taxpayers). If the campaign to induce greater saving and later retirement is successful then current consumption will be lower than it would have been, and employment participation greater than it would have been, at the same time as GDP is below potential and this potential is growing rapidly through technological innovation. The conclusion must be that GDP will remain below potential and that the owners of the means of production will find it difficult to convert their share of GDP to monetary wealth in the shape of profits. This will eventually discourage investment and productivity growth. It will slow the growth of potential. It makes little sense in aggregate to pursue the ‘save more, work more’ policies and as was noted in Economics 8 one needs a mechanism for distributing the growing cake more widely without discouraging the owners of the means of production from expanding the size of the cake. Laissez faire philosophy has nothing useful to say about this problem and its concern (moral hazard) is generating policies that may make matters worse. The problem is that income distribution and wealth creation are connected and modern economics simply ignores the fact.

The financial life cycle means that at any point there will be individuals accumulating claims on future GDP (saving) and those spending past accumulations of claims on current GDP (dissaving). There is no reason the two should be the same and the logic of the ‘save more, work longer’ pressure is that the former will exceed the latter. So what happens to current GDP? Owners of the means of production may use some unused GDP to invest but this merely increases the size of potential GDP. It defers the problem and, in so far as the growth of potential is rapid, may make the problem worse. The state is also saving, by reducing borrowing and the social wage. Unless foreign demand takes up any slack in potential GDP, GDP will be below potential. There will be poverty in the midst of plenty (of potential GDP).

To recap:

1. Laissez faire philosophy argues that we begin with a genetic and social inheritance and it is up to us to make the best of it.

2. The financial life cycle is simply that the adult begins life typically with zero to negative wealth, saves from income and accumulates wealth, spends from saving when no longer able to work.

3. Laissez faire philosophers invoke moral hazard to argue that the social wage should be minimised, studiously ignoring the fact that not everyone starts from the same place, has the same luck or makes the right decisions. They ignore inequality and indeed celebrate it as the driving force of the market system.

4. The response to the so-called pension crisis is thus to urge greater saving and longer working lives at a time when GDP is below potential and the potential is on the verge of a surge in growth owing to productivity gains. How will the owners of the means of production realise profit in monetary terms if no one can buy their claim on GDP? The connection between income distribution and GDP growth appears again.

5. To get some semblance of balance, savers must match dissavers on average (otherwise claims on GDP will not match). The universal pressure to save is creating a trend towards excess of saving at the same time as potential GDP is growing rapidly. The economy could get stuck at below potential GDP for some time.