Friday, March 11, 2016

Joanna Masel — How Your Savings Plan Fuels an Arms Race on Wall Street

Policy makers are keen to encourage people to save more money for retirement, e.g. via tax incentives. This is great advice for individuals; the more money an individual saves, the more comfortable their retirement. But is it also a good idea for society as a whole? What happens when everybody tries to save money at the same time?
To answer this, we need to understand the distinction between relative and absolute competitions. Think about a running race. An absolute competition pits each runner against the clock. In an evolutionary contest, where anyone who finishes the race in less than a certain time is allowed to have children, those with stumpy legs and flat feet will be replaced by the children of the fast runners. In future generations, the average person runs faster.
In contrast, in a relative competition, where competitors race in pairs against one another instead of against the clock, rules of fair play do not apply. One competitor is super fast. Unfortunately, he gets tackled from behind. In the ensuing brawl, he receives a solid blow to the head and passes out. The slower guy then wins. In each generation, the competition gets tougher, but not necessarily because the new generation runs faster. Strictly speaking, this relative competition does not favor being fast. What it favors is crossing the finish line before your competitor. Running fast is one way of crossing the finish line first. But evolution is a creative process, and there are many different ways of achieving the same goal. It is hard to predict which of the many solutions will triumph, and not all of the solutions are ones that we like.
If saving for retirement is an absolute contest, then policy makers are doing the right thing when they encourage people to save for retirement. But if saving for retirement is a relative contest, the incentives we give for retirement plans may achieve nothing, or even worse, do economic harm.
In the real world, it’s sometimes hard to figure out which competitions are relative and which are absolute. But the mathematics behind the two are different, and so are their outcomes. During my training in evolutionary biology, I learned to use a standard mathematical model in which competition was relative. In contrast, economists learn standard mathematical models that are based on absolute competitions. These default assumptions, built into the curriculum, can shape the way someone approaches a problem for the rest of their career.
As a result, economists are biased towards assuming that competitions increase prosperity. Evolutionary biologists like me are trained to have the opposite bias, instead assuming that competitions are zero-sum. In both cases, the truth is probably somewhere in between, but how we are trained affects which situations we see as “normal” and which as “special”, and which sort of mistakes we are most likely to make.
My recent book argues that saving for retirement has become a relative contest, but that economists dangerously mistake it for an absolute one.
Saving does not cause investment.

How Your Savings Plan Fuels an Arms Race on Wall Street
Joanna Masel


mmcosker said...

Hmmmm. Maybe I am nitpicking, but seems that savings can cause investment. The institutions that serve savers do make investments in real resources to meet saver's demands, invest in data centers, websites, buildings etc.... Savers are consuming financial products.

Tom Hickey said...

Some saving do cause some investment at the micro level, eg., entrepreneur invests savings in startup, but not at the aggregate level of aggregate saving "causing" aggregate investment, as some read the accounting identity S = I as implying.