Dissertation Topic 3: Public Savings Systems that Lift the No-Margin-Buying Constraint

QUESTION: Miles, I am a 2nd year Phd student at the University of Athens,Greece and i would like to write a strong proposal to continue the Phd abroad (I don’t think you need details about why, just read the headlines!). I was reading your papers about precautionary savings and i was thinking to study the impact of social security on savings and investment behavior of the households. What do you think and where should I focus my attention? Thank you in advance!

I find this subject intriguing because I believe that the relation between healthcare systems, saving and macro performance is strong. The first two have been investigated extensively, but not for Europe despite the fact that the “experiment” is interesting due to the diversity between countries with respect to healthcare systems since data are relatively recent (thanks to S.H.A.R.E.). For the second pair I think that distorted saving affect the economy severely. Households savings are substituted by government and this could potentially affect the structure of the economy. For example some countries regulate the investing decisions of public institution and constrain to invest nationally and safely (usually national bonds!). Ideally i would like to focus in the most fruitful research topic and construct a theoretical model with heterogeneous agents and test it empirically.I understand that my questions are very broad and i need to narrow them.

ANSWER: In this area, I think there is a very interesting contrarian research project. Given even a modest positive equity premium (expected returns of stocks higher than expected returns of bonds), models of optimal life-cycle saving and portfolio choice suggest that–if only they could freely do margin-buying at the Treasury-bill rate and with no extra investment fees–young people should typically have what seem like very large investments in the stock market because the present value (total asset value) of their many years of future labor earnings is in the hundreds of thousands, or even millions of dollars, making substantial stock-holdings reasonable. Even at my age, if I knew how to do margin-buying conveniently at the Treasury-bill rate with no fees in order to effectively borrow to hold more stock than the total value of my retirement savings plan, I would do it, but I can’t. But government retirement savings programs could make this possible. Moreover, if the political flak could be survived, a public program is a way to overcome the fact that most people don’t understand the principle that they should integrate future labor earnings into their financial investment decisions.  (There is a lot of evidence to back up the fact that in the real world most people don’t understand this, even though in standard economic models, all of the “agents” serving are theoretical stand-ins for human beings understand this principle with perfection.)

As someone writing an economics dissertation, the political flak that such a program would entail is not your problem. Showing that it would substantially raise welfare if it ever happened would be very interesting. I think this is a research project that would intrigue people because it sounds so counter-intuitive, especially in the context of the current economic troubles, yet is so firmly founded in sound economic theory.

By the way, the idea that people ought to have large stock holdings even if the expected returns on stocks are only modestly above the expected returns for bonds is dramatically reinforced if one is willing to follow Raj Chetty in estimating risk aversion using labor supply behavior. I love this paper:

Raj Chetty, “A New Method of Estimating Risk Aversion”

American Economic Review, 96(5), 1821-1834, December

Using Raj’s numbers for risk aversion amounts to saying that only declining marginal utility is a sound reason for avoiding risk and that any aspect of apparent risk aversion that comes from departures from the standard expected utility theory does not deserve respect in thinking about the normative (prescriptive) question of how much risk people should take on in order to get higher expected returns.

I personally would find a job market paper that pursued this idea seriously and well quite exciting, and I don’t think I would be alone.  

This project would be computationally intensive. For style of paper, you might want to consider something like my paper “Portfolio Rebalancing in General Equilibrium” with Matthew Shapiro, Tyler Shumway and Jing Zhang or the partial equilibrium counterpart to that paper.