Aggregate Risk, Political Constraints and Social Security Design

24 Pages Posted: 23 May 2002

See all articles by Marcello D'Amato

Marcello D'Amato

University of Salerno - Centre for Studies in Economics and Finance (CSEF)

Vincenzo Galasso

University of Lugano; Centre for Economic Policy Research (CEPR)

Date Written: April 2002

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, political bailout, moral hazard

JEL Classification: D72, H55

Suggested Citation

D'Amato, Marcello and Galasso, Vincenzo, Aggregate Risk, Political Constraints and Social Security Design (April 2002). CEPR Discussion Paper No. 3330. Available at SSRN: https://ssrn.com/abstract=313644

Marcello D'Amato (Contact Author)

University of Salerno - Centre for Studies in Economics and Finance (CSEF) ( email )

84084 Fisciano, Salerno
Italy
+39 089 962074 (Phone)
+39 089 962339 (Fax)

Vincenzo Galasso

University of Lugano ( email )

Via Giuseppe Buffi 13
Lugano, 6900
Switzerland

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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