Working Paper: CEPR ID: DP3330
Authors: Marcello Damato; Vincenzo Galasso
Abstract: In a stochastic environment, with political constraints, we analyse the behavior of a fully funded system, whose portfolio is composed of a risk free and a risky asset. When an aggregate negative shock hits, a large share of the wealth of the elderly is wiped out and office-seeking policy-makers ?bail them out,? by instituting a long-lasting PAYG system. Under these political constraints, a fully funded system suffers from a moral hazard problem, since agents have an incentive to choose a riskier portfolio, which increases the wealth loss associated with the bad state. The introduction of a mixed system reduces the riskiness of the portfolio, which remains however higher than in the case of no policy-maker?s intervention. Furthermore, the early adoption of a mixed system, previous to the occurrence of a negative shock, eliminates the policy-maker?s incentive to intervene, albeit at a high cost. In fact, its unfunded pillar would be larger than the PAYG system introduced in the case of a bad shock. In our dynamically efficient economy, this would amount to impose an extra loss on all future generations.
Keywords: Fully Funded; Moral Hazard; Political Bailout
JEL Codes: D72; H55
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Political constraints (D72) | Introduction of PAYG system (H55) |
| Introduction of PAYG system (H55) | Increased consumption of the elderly (J14) |
| Negative aggregate shocks (E19) | Introduction of PAYG system (H55) |
| Introduction of PAYG system (H55) | Moral hazard for young agents (D82) |
| Moral hazard for young agents (D82) | Reduced savings and riskier portfolios (D14) |
| Mixed system (P40) | Mitigation of moral hazard (G52) |
| Mixed system's unfunded pillar (H55) | Larger than PAYG system in response to negative shock (E19) |