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Masaccio: The Shaky Foundation of Neoliberal Economics – Life-Cycle Savings

Posted on October 8, 2014 by

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Yves here. Readers may know that we regularly savage neoliberal economics, which we often refer to as “mainstream economics.” For instance, that’s why we so often take aim at Paul Krugman, who despite his leftist inclinations, never takes them very far because he is intellectually hostage to a flawed, destructive orthodoxy.

We wrote an entire book, ECONNED, devoted to what is wrong with neoliberal economics and how fealty to its precepts produced the global financial crisis. Other economists, such as Steve Keen in his Debunking Economics, have provided even more exhaustive critiques.

Here masaccio makes a point that the many enthusiastic reviewers of Piketty’s Capital in the 21st Century have skipped over, namely, that his book indicts orthodox approaches and conclusions. Masaccio then focuses on a glaring example of where neoliberal economic theory does not match up with behavior, in its life cycle savings theory.

By Ed Walker, who writes as masaccio at Firedoglake. You can follow him at Twitter at @MasaccioFDL, and here’s his author page at Firedoglake.

In the US only one economic theory gets a hearing in any policy discussion. That theory, neoliberalism, has gotten a 42 year tryout, beginning with the inauguration of Ronald Reagan and running forward through today. It has proved to be wholly and totally wrong, and the more firmly politicians grabbed onto it, the worse things got. The final collapse, the Great Crash, could have been a sign that this theory is comprehensively wrong, and that we desperately need a new set of ideas for coping with the destruction. Instead, President Obama, chose to hire courtiers like Larry Summers, the Bankers’ Man at the Fed, Timothy Geithner, and a coterie of disciples of Robert Rubin to advise him. Together, they did everything they could to restore the power of the financial sector at the expense of millions of us. Within a few months, the neoliberals were back at it, demanding tax cuts and less government, insisting on crushing beleaguered homeowners, handing out more tax cuts, stripping the unemployment compensation of the involuntarily unemployed, and generally swaggering around like they owned the place. The neoliberal crowd won every single battle over the way the government responded to the nightmare. How is it possible for such a destructive theory to survive, let alone triumph in the wake of its disastrous results?

One reason among many is that practically everyone of every social class in the US is a true believer in one or another bastardized version of free market capitalism. The elites normally ignore the views of the lower class, those in the bottom 50% who have no wealth, but in the case of economics, it serves the interests of the richest that the poorest are the biggest supporters of rampant capitalism. Among the top half, there is near-universal support for neoliberal economics, in both of the mainstream parties, and in the media. The only difference seems to be the intensity with which those views are held, and the amount of pain they are willing to inflict on others in pursuit of the neoliberal vision.

A lot of college-educated people took one or two introduction to economics courses, and that was enough to cement in their minds the basic theories and the basic approach to the field. So, when they hear people talk about markets, they remember those simple graphs, and those simple exercises, and nod their heads wisely.

A lot of what we were taught in intro econ seems like common sense. The ideas are simple and catchy, and they seem to fit in with what we were told by our parents, and what little we then knew of the world. If the stories didn’t seem to quite fit our first jobs, we didn’t really notice, we just treated our new information as if it were a special case, and continued assuming that the rest of the world was different, more like our econ courses. In the aftermath of the Great Crash, it was much easier to blame someone for the problem, rather than question the basic theory. It was the savers in China, the greedy masses ready to lie to get in on the American Dream, or any one of the myriad excuses offered by the neoliberals and their flacks, all of who sprang into action to distract us from questioning the basis of their theories.

That helps explain why Capital in the Twenty-First Century by Thomas Piketty was such a sensation. Piketty gave US economics a try as a young grad student at MIT. He doesn’t think much of it, with its “childish passion for mathematics and for purely theoretical and often highly ideological speculation, at the expense of historical research and collaboration with the other social sciences.” 32. He shows how data can be pulled from old archives, sorted, cleaned up, and organized into useful forms. From these forms, we can learn what happened. From history and literature, we can see how people lived in those periods, and we can draw useful inferences.

That’s so different from the US form of the subject, where what to the layman looks like complicated math (it isn’t) pushes us away from our own examination of the ideas and towards acceptance of academic scholarship. We don’t think we can do better than the academics because we think they have some special expertise. The media treat these people like Possessors of the Truth, and delight in explaining how smart Larry Summers is, and how lucky we are to have him and his ilk handing out advice to politicians and hedge fund leaders.

We learn from Piketty that most of the assumptions that form the basis of economic theory are not tested against actual data. They rest on simple assertion accompanied by lots of hand-waving. Even the definitions are arbitrary, and shift about as needed to fit the theory. Academic advancement rests on coming up with some kind of intuition about the nature of the economy, and restating it in mathematical symbols to see if it fits with the existing pile of similar studies. Here’s a bald example:

The prudential regulation and supervision of the financial sector are meant to reduce systemic risk and other risks that arise from asymmetric information. They may therefore be of benefit to the regulated financial institutions themselves: precisely because of the systemic features of a financial system, each individual institution has an interest in the soundness of others. Hence, an institution may welcome regulations even if they impose compliance costs in the form of higher operating expenses and restrictions on its portfolio choices. The model presented here formalizes this intuition, and indeed suggests that in some instances financial institutions or at least a dominant group of institutions may favor regulations that are excessively restrictive relative to the social optimum.

That conclusion could just as easily have been drawn from the first two sentences. The math added nothing.

Throughout Capital, Piketty takes swipes at the assertions of neoliberal economic theory. He certainly isn’t the first person to suggest that individual intuitions of neoliberal economics are wrong. But he identifies so many that it begins to call into question the entire edifice of a theory that is obviously a failure in the real world. And, he postulates a new idea: that data can be used to test out the assumptions and even replace assumptions with facts. Reliance on data carries with it the message that we can’t assume that the future will be like the past, so our answers are always provisional. Finally, he arms the willing reader with the confidence to take on the entrenched economic elites.

As an example, let’s consider the life-cycle consumption theory of Franco Modigliani, which won him the economics version of the Nobel Prize. It says that people save in the present so they can consume later. In this theory, saving is a way to smooth out consumption over a lifetime; you consume less today so you’ll have money later when you need it, for college expenses for your children, unemployment, illness or retirement. This intuition is used today by economists such as Simon Wren-Lewis and Angus Deaton. The latter, a professor at Princeton, produced a paper in 2005 extolling the theory and claiming that was a powerful insight into the way things work. Among other things, it is used to create consumption functions.

Piketty takes it up in Chapter 11, discussing the amount of national wealth attributable to inheritance as compared to the wealth attributable to savings from labor income. Modgliani put out a couple of papers in the mid 80s arguing that as little as 20-30% of the total wealth of the US was the result of inheritance or lifetime gifts. Piketty thinks it’s higher. In his discussion, he points out that the theory implies that by the time of death, you have little or nothing left over to pass on to your heirs. It also implies that the elderly spend down their wealth in the years before their deaths. You don’t need to be an econometrician to check this out for yourself. There is plenty of recent data that anyone can find to check for themselves.

First, we know that the net worth of the bottom half of the population by income is very low. According to the 2013 Fed Survey of Consumer Finances, the median net worth of the lowest quartile is negative, and the median net worth of the next higher quartile is $31,300, down from $34,500 in the 2010 Survey. According to a different 2013 survey by the Federal Reserve, 52% of respondents would not be able to come up with $400 for an emergency without selling something or borrowing. About half of respondents have no plans for how they will retire. Obviously this half of the population isn’t saving, so the theory can’t be right as to them.

At the other end of the spectrum, we find the wealthiest decile, whose median net worth was $1.88 million according to the 2013 SCF. Few of these people will spend all their assets. Almost all will leave substantial wealth to their children and grandchildren, through bequests or through large lifetime gifts.

Somewhere in the 50th to the 90th percentiles there is no doubt a group of people who are saving, either for college for their kids, emergencies, or retirement. According to the 2013 Survey, about 60% of households in the third quartile saved money, and about 70% in the 75th to the 90th percentiles saved money. In the top decile, 80% were savers. For this purpose, paying down debt, including unsecured debt, counts as savings. These figures do not support the life-cycle hypothesis.

The Survey doesn’t support the prediction that the elderly spend down their wealth. About half the households with a head of household 65 or older were savers. That’s pretty much the opposite of the theory. There’s a study by the Chicago Fed reviewing data from Asset and Health Dynamics of the Oldest Old, data collected in surveys by workers at the University of Michigan. They started with about 7500 participants over the age of 70, including about 2500 older than 80, and about 800 spouses younger than 70, Data collection began in 1995, and the population was surveyed every two years.

The Chicago Fed study looks at the period 1995 to 2002. The principle result is that households in which no one died during the period did not consume their wealth, but instead adjusted their consumption to maintain their wealth. Households in which there was a death saw a decrease in wealth. In those households, the average wealth was $120K at the beginning of the period, dropping to about $60K at death. In the whole sample, average wealth among married was about $345,000. If their wealth decreased at the same rate in the period before death of both spouses, we might conservatively estimate that the total loss would be about $120K (which doesn’t allow for any additional accumulation of wealth). That supports the idea of some dissaving among the oldest almost all of it in the last year of life, but it also means that most who have wealth to start with end up with substantial wealth.

In sum, the data doesn’t support the life-cycle consumption theory. It might be a good idea, and lots of us might try a bit of it, but the facts say that most of us don’t do it. Let’s stop using it as an assumption. We should think of it as a bit of the Jenga Pile of neoliberal economics that we were able to pull out. How much do you have to pull out before the whole thing collapses?


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