Developed democracies in the early 21st century are facing similar problems of debt, low domestic savings rates, ageing populations, rising dependency ratios and social spending and the pressures these place on public finances.
The trend has been away from people managing their own risks to extension of social risk-shifting devices that are largely publicly-funded. Shifting risk from individuals to government has eroded individual motivations and locked in entitlement expectations. Welfare entitlements are “sticky downwards,” making it difficult for governments to reduce them.
Developed economies that are on the edge of the technological frontier cannot sustain the growth rates achievable by developing countries that can catch up fast by adopting and improving on existing technology. Productivity gains and faster rates of economic growth in developed countries cannot meet all future entitlement demands.
Defining the problem
In developed countries most targeted support for low income people has been subsidies for consumption through income support, rather than through capability and asset enhancement aimed at lifting people’s ability to eventually generate higher incomes for themselves. It is remarkable how little scrutiny has been applied to income support as the preferred social welfare route in developed economies, especially given its effects on motivations and behaviour.
Consumption-based social welfare policies often conceal liabilities for future governments. They have self-perpetuating features since they create bureaucracies with interests in their own survival. Social welfare policies can also create dependency and then perpetuate it by eroding people’s motivations and depriving them of the psychological resources that can support a developmental path forward.
Government seeking to take risk from people erodes the savings and asset formation that people might engage in if they have to protect themselves from such future risks as unemployment or business failure. Consumption-based social policy reduces savings and investment and therefore the productivity growth needed to support higher levels of future consumption.
New Zealand’s economy is a good example of the above difficulties. It under-saves and over-consumes. Low domestic savings leads to low productivity and to a high current account deficit. This in turns damages the competitiveness of the export sector, and suppresses wage rates across the economy. The rising demands on government for pension and health care funding puts increasing pressure on public spending and this further reduces savings, investment, productivity growth and export performance.
Some developed countries are reducing social spending as part of austerity programmes to reduce public debt. However reducing social entitlements affects lower income people more and exacerbates economic inequality. Rising inequality is self-compounding because of “Spirit Level” effects where economic and rank status inequality generates secondary social problems such as poor health, which in turn reduces productivity and generates further health and other costs.
Reducing entitlements may also lead to wider macroeconomic problems depending on timing and sequencing issues and external macro-economic issues. It can lead to or exacerbate recessions leading to a downward spiral of unemployment, lower tax takes and rising public debt.
A way forward
A response to the above difficulties may be a strategy to change the pattern of social expenditure from consumption to wealth-creating saving and investment. This can be done in ways that maintain and perhaps enhance the net fiscal or other transfers to low income people, but change the composition of these transfers from consumption to a capability development approach that supports asset formation, higher productivity, and therefore provides a foundation for higher levels of future consumption. This raises a transitional issue. To save and invest, consumption levels must drop in the short term. This becomes a management of change challenge for both governments and households.
What do we mean by a “capability development approach?” Active capability development aims to build wealth-creating capabilities such as skills, knowledge and assets. These capabilities are internal to an individual, however their creation and economic expression involve external influences and conditions.
For example, savings are a function of external institutions, framing and incentives not just of income. Building an internal capability such as financial literacy is inadequate by itself unless we also address such external factors as the regulation of consumer financial products, and the framing and choice architecture of, for example, credit offerings.
Capability development is a long-term phenomenon and needs to be supported by protections against short-termism. It requires self-regulation to reduce consumption and to save and invest in capability development. However, people are subject to peer pressure, consumer advertising, finance industry psychological manipulations, “easy credit,” and temptations to gamble that erode this self-regulation. Consumerism and social norms that support it and the finance industry’s workings undermine self control. This suggests that capability development may sometimes require “ties that bind” and some element of compulsion, for example in savings schemes.
A move from passive social welfare dependency to active capability development might be seen by some as a “neo-liberal”, socially conservative or “right wing” economic strategy that starts from a punitive view of social welfare dependents.
However, it could be implemented in parallel with reductions in “middle class” privilege and hidden subsidies. These can include untaxed capital gains, and middle class transfers such as tertiary education and some home ownership and retirement subsidies. Any transitional costs associated with a move from income support to capability development could be met by reductions in such “middle class welfare”.
A move to capability development welfare policies aims to lift productivity and therefore per capita income, and to do so in ways that reduce asset and income inequality. It aims to redistribute through growth and social mobility rather than through static tax redistribution. It seeks to do so in ways that also enhance people’s control over their own lives and their competence, autonomy and relatedness.
A capability development approach needs to focus effort on people at critical stages of the lifecycle rather than on responses to pressure groups. This is why some countries have developed savings schemes that have different sub-accounts or different rules applying at different life stages.
A capability development approach also needs to be reinforced by a “moral narrative” governing how people should behave. Adam Smith showed how prosperity comes from individual self interest, specialisation of labour and trade. He also believed in people’s need for others’ esteem that is earned through a code of conduct. Therefore the external effects of social norms, and agreed views on how people should behave are needed for a capability development approach to succeed.
To illustrate, a capability development approach could be applied to social policy fields such as superannuation, income support for working families, and accommodation subsidies:
“Pay as you go” superannuation systems can be well-designed and equitable however they do not contribute to building up savings and investment and increasing the depth and sophistication of capital markets. “Save as you go” schemes involving compulsory earnings-linked savings can fund superannuation entitlements while also enhancing national savings and investment. However, earnings-linked savings can compound income and asset inequalities so that working age inequalities are perpetuated into retirement and old age. This can be exacerbated by the physical demands of low income manual and other work that makes it more likely such workers will retire earlier due to health and disability issues.
To address these problems, a move to compulsory earnings-linked saving, perhaps complementing a “pay as you go” universal entitlement scheme could be supported by other subsidised savings mechanisms focused on low income or low asset people. Many countries encourage and often subsidise savings schemes to support education, financial asset development and home ownership.
Income support schemes for working families can subsidise consumption for low income working people with the intention of maintaining living standards. However income support to keep people out of poverty does nothing to build capability that gets people onto a developmental pathway. It can effectively keep people in poverty. It can also indirectly reduce working people’s incomes by reducing pressures for wage increases and discouraging business investment in labour-augmenting capital equipment.
A capability and wealth-creation approach would convert such income support for consumption to a suite of investments in, for example, children and young people’s education, share and other financial asset investments, working age education and training for parents, support for home ownership and so on. The direct effect of this would be to lift the future earning potential and assets of family members. The indirect effect would be to lift the productivity of the family members who become better educated and skilled and of the economy as a whole as money that would have been consumed is converted into savings and investment, enhanced human capital and therefore into higher productivity.
Such a move from income support to capability development would theoretically be fiscally neutral in the short run for both government and the household, and would in the longer term be positive for both parties. An increase in savings and productivity-enhancing investment would lift growth and tax revenues and strengthen the government’s overall financial position. Investment in individual and household capability at the expense of current consumption would allow higher levels of future consumption to be supported by the household’s greater productivity and stronger asset base. In practice of course, there are likely to be transitional costs to move from an income support to an active capability development social policy model.
Accommodation subsidies in developed countries can end up being capitalised in landlord assets or incomes. A capability approach suggests active assistance for home ownership, for example by encouraging state or social housing tenants to buy their own homes, and provision of home ownership subsidies. Subsidies for home ownership, including through low cost and cheap credit can lead to housing bubbles and can draw resources away from the tradeable sector and exacerbate macroeconomic imbalances. A move from accommodation subsidies to active promotion of home ownership therefore needs to be supported by initiatives to enhance housing supply, for example through regulatory change, state house building programmes and so on. It may also need to be phased in gradually.
Many developed countries are facing the effects of recession and rising social welfare burdens, all within a context of uncertainty about possible future financial crises. It is tempting for governments to focus purely on strengthening their balance sheets and therefore enhancing their ability to address future financial crises. Much of such austerity would impact on social spending. However, cutting such spending can simply compound social problems that to some extent result from low wealth-creating assets and capabilities and the psychology associated with this. Cutting social spending will not itself change behaviour from passive to active, nor will it enhance a society’s productivity or wealth-creating capability.
Rather than cutting social spending a better strategy is to convert it from passive to active and from consumption to asset and wealth creation at the individual and household level. This then aggregates into greater economy-wide savings and investment and higher productivity and into an improved current account position and therefore enhanced international competitiveness. This improved productivity and competitiveness translates into enhanced earnings and therefore gives people the ability to save more as well as enjoy higher living standards – a virtuous circle.
Moving to a capability development approach means people become active not passive, exercise more volition, and are better able to fulfil their potential. When individuals behave this way then it starts to become the social norm.
Giving people more control over their own lives is associated with wider psychic benefits such as lower stress levels and more social cohesion. It may also help people see more clearly the conditions of life and make them more realistic about what governments and they themselves can do. After all, ageing and its attendant ills are inevitable and predictable and government cannot abolish them. A move from passive consumption to active capability development reinforces a philosophy of self-determination over those parts of one’s life that one can control, and an acceptance of things beyond the control of both individuals and governments.