I am very pleased to be invited to speak to such a distinguished audience of funds managers. Since one of your main tasks is to invest the community's retirement savings, you will be familiar with the challenges that are facing retirement incomes policies in all countries, including Australia. I would like to say a little about this, but will not dwell on it because you will be hearing from experts like Vince FitzGerald later in the conference. My interest in retirement incomes policy today is that it highlights an issue which I believe is common to other macroeconomic policies – namely, the inter-generational issue.

Retirement Incomes Policy

The main challenge is how to finance pensions in an ageing population, ie where the proportion of the population who are pensioners is rising, and the proportion in the working-age group (whose taxes are paying the pensions) is falling. This is not a pressing issue at the moment, but will grow over the next 30 years. All countries are grappling with this problem, and in some the outlook is quite alarming. Australia fortunately is in a better position than most for two main reasons.

• First, our demographics are more favourable because our population is not ageing as fast as most other countries, and so our dependency ratio is not likely to rise as fast. We can thank our high rate of immigration for this.
• Second, we have moved relatively early in the piece to make a significant change in the funding of retirement income. I apologise for sounding overly technical at this point, but I do not know of a simpler way of describing our changes than to say we are supplementing our unfunded publicly provided defined-benefit scheme (known as the old-age pension) with a publicly mandated, but privately managed, defined-contribution scheme (which, by definition, is fully funded). We already had a small private superannuation sector, but we are trying to expand it in place of the public one. Given that there is a means test on the public one, over time it should shrink and be substantially replaced by the privately managed one.

While the problem of retirement income financing is less urgent in Australia than in most other countries, it does not mean that we do not have one. On present trends, our dependency ratio will rise noticeably in the early part of the next century (Table 1). Had there been no changes to retirement incomes policy, there would be a relatively sudden need to raise taxes at that time to cover these outlays (and associated increased outlays on health). I wonder how enthusiastic the next generation of workers would be about a tax increase of this type, and what sort of social and political pressures it would produce.

Fortunately, steps have been put in place which will see mandatory superannuation contributions by employers rise from their original level of 3 per cent in 1986 to 9 per cent in 2002 and a proposed 15 per cent including employee and government contributions. This policy has bipartisan political support, which is a tribute to Australia's capacity for change compared with most OECD countries. Whether it will be enough, whether there are too many leakages still remaining or whether there was a simpler solution, will remain subjects for debate. But even so, it is still an impressive achievement.

While the motivation for this change was mainly a desire to increase national savings, there was also a case for doing something on the grounds of inter-generational equity. Almost by definition, any retirement savings policy, other than a defined-contribution one, has inter-generational implications, and it is difficult for the political processes to come up with one that is fair, given that future generations do not have a vote in its original design. I would like to put forward the view that inter-generational equity is much broader than retirement incomes policy; it is at the heart of both fiscal and monetary policy, and hence is central to a number of challenges we face today. I would like to use the rest of this talk to spell this out.

Fiscal Policy

There are a number of ways in which fiscal policy decisions taken by members of this generation can impose a burden on future generations.

• The most obvious case is where recurrent spending runs ahead of taxation and the government runs large structural budget deficits. In developed economies, the usual way of plugging this gap (and the least disruptive) is by borrowing from the public. There is nothing wrong with government borrowing if it is to finance long-lived assets from which future generations will benefit, but borrowing to finance recurrent expenditure is merely pushing a burden onto the next generation. It is their taxes which will have to service the borrowing. Of course, public borrowing is not the only way of financing a deficit; the alternative that is used in a lot of developing countries is to borrow from the central bank, which is known colloquially as resorting to the printing press. This is a sure recipe for inflation, which will also have inter-generational implications.
• Even if expenditure is matched by taxes, and the government never runs a deficit, it is still possible for inter-generational implications to arise. Any deliberate decision to increase a benefit, such as the old-age (or other) pension, bestows a windfall gain on some members of the generation that is about to receive it, but whose taxes had been based on the earlier less-generous benefit regime. This problem becomes particularly severe where the increased benefits are received by a large generation, but the succeeding generation of working age, which pays the taxes, is smaller as a proportion of total population.^[1]
• Any introduction of a new benefit or eligibility criterion, which turns out to be more widely used than expected, has the same effect as the previous example, ie it pushes up the next generation's taxes. In this case, because the results are unintended, the measures may not have been voted for, even by the initiating generation, if the consequences had been foreseen.

It is easy, and usually popular, to introduce a new benefit or to make an existing one more widely available. But it is difficult to remove existing entitlements because it is always politically unpopular, and there may be large human costs as a result of dependency. This gives a bias towards increasing current expenditure and future levels of taxation, a bias that is readily apparent from the experience of all OECD countries over the past 30 years (Graph 1).

One reason why this bias has arisen is that each generation has an incentive to bestow benefits on itself, while neglecting the interests of future generations which do not have the vote. Another reason for the bias is that the spenders are often seen in the public debate as compassionate and generous people, and those who favour restraint as Scrooge-like accountants. One could, however, equally view it as a contest between those who are willing to take advantage of the next generation and those who wish to protect it.

There has recently been a lot said and written about the population's (or the electorate's) dissatisfaction with governments and economic performance in general. Much of this is attributed to the fact that governments everywhere are engaged in fiscal consolidation by cutting expenditure and/or raising taxes and charges. There is no doubt a lot of public dissatisfaction on this score, but governments are not doing it because they like inflicting pain or they like losing elections. They are doing it because in many countries, particularly the European welfare states, the fiscal position has become untenable.

An alternative explanation for this dissatisfaction is that, when fiscal action is required, it falls very unevenly. The first solution to growing fiscal deficits was to raise taxes, but there is less scope for this now that the limits of tolerance have been reached. The more common course now is to cut expenditure where it can be cut. With cuts to entitlement spending virtually ruled out, the cuts have had to fall elsewhere. The main result is that government service provision has failed to keep up with community aspirations, and government capital works have been cut back or privatised. For the majority of the population, who do not see themselves as recipients of the entitlement spending, governments are regarded as providing an increasingly poor service and charging too much for it.

Monetary Policy

It is now accepted that monetary policy's principal long-run effect is on the rate of inflation, and that therefore its main objective over that horizon should be to ensure low and stable inflation. This is not to deny that it has large effects on economic activity and employment in the shorter term, and that these effects have to be taken into account in framing policy.

There is an increasing economic literature which aims to spell out the costs of inflation. I do not intend to go over it at this stage, but merely to point out that it has never been as convincing as it should have been, because it has tended to leave out the distributional effects of inflation. The first distributional effect is between different people at a given point of time, and the second is between different generations. I would like to say something about these, particularly the latter.

• High inflation enables the financially sophisticated (usually the better-off members of the community) to put into place strategies whereby they actually benefit from inflation. Most of these strategies involve taking advantage of the fact that the accounting and tax systems are based on nominal magnitudes, and so open up profitable opportunities in an inflationary environment. The most common such strategy involves the geared acquisition of assets which increase in value. In this way, inflation usually leads to a redistribution of wealth towards the richer parts of the community.
• If we look over a longer time horizon, it is clear that there are also inter-generational shifts of wealth occurring. The example closest to hand is the big rise in inflation that started in the mid 1970s, and continued for much of the 1980s. There can be little doubt that some people benefited considerably from this. I have already said that the financially sophisticated were big gainers, but, in addition, gains and losses were distributed according to where people were in their life cycle. With the real price of houses rising substantially during this decade, the generation that owned the houses made a windfall gain at the expense of the generation that had not yet entered the market.
• Unlike undisciplined fiscal policy, which can only involve the current generation harming the next one, monetary policy can work in the opposite direction. The best example of this is the Weimar inflation in Germany in the early 1920s. The older generation of Germans held their retirement savings mainly in the form of government bonds (which had been raised to finance the First World War). The hyper-inflation of 1923 reduced that generation's wealth to virtually zero, but the next generation gained by not having to pay the taxes required to service the government debt.

There are some interesting corollaries between undisciplined fiscal policies and lax monetary policy. Just as there is often electoral pressure to increase government spending, a rise in inflation, at least in the early stages, appears to many people to be an attractive prospect, or at least not a serious problem. Usually it is accompanied by a boost to economic activity; and increasing pay packets and house prices give people an illusion of increased economic security. But every country has found that inflation has to be brought back eventually, even though doing so is a painful business. It is not unreasonable to argue that one of the greatest costs of inflation is the cost of bringing it down again. The benefits of inflation are small and fleeting, the costs and distortions gradually become greater, and the cost of finally stopping it is large and painful.

In that sense, there is a clear similarity with fiscal policy, but there is also a big difference. The difficulties of turning around an unsatisfactory fiscal position have proved too great for most countries. The government's share of GDP is still trending up in most countries, and fiscal deficits are as big a problem as they have ever been. On the other hand, a determined effort on monetary policy has brought inflation in the OECD area back to rates that have not been seen since the 1960s.

Conclusion

My general proposition is that economic policy should be conducted so as to prevent one generation getting more than its fair share. That is, it should stop each ‘present’ generation from expropriating income from following generations.

These inter-generational shifts have certainly occurred in the past, but I do not want to give the impression that these processes have necessarily involved conscious decisions or conspiracies. Usually, the motive has been generosity – the desire to transfer income from one group in the present generation to another group who are regarded as more deserving. Often, however, it has also resulted in a transfer from the next generation to the present one. On other occasions, it arises because of a failure to resolve conflicts about how to divide up the existing pie between competing groups; the solution can involve a compromise where the burden is pushed onto future taxpayers.

The best way of preserving inter-generational equity is to run conventional ‘good’ fiscal and monetary policy, but this is not easy, as the past 20 years have shown. In democracies, there are many pressures for spending now and paying later, but there is not much of a constituency representing future generations. Those who are interested in handing on to future generations an economy in good shape should welcome any moves to increase national savings by such measures as improved retirement incomes policies and sounder fiscal policies. They should also make their views known in order to counteract the vociferous demands of the special interest groups. Unfortunately, as I said before, people who believe in these things are often painted as lacking in compassion and being subject to no higher motivation than a belief in managerial efficiency (notice how often they are accused of having a fetish about the deficit). I would submit that, in general, they do have a higher motivation, and that it is to perform the role of trustees for the next generation.

Footnote

In principle, these effects can be quantified by the technique known as Generational Accounting. It compares the lifetime net benefits/costs that accrue to succeeding generations from the one born today, onwards. Unfortunately, it does not say anything about those already in the workforce or about to enter it. [1]