Vernon Smith, now a professor of economics and law at George Mason University, won the 2002 Nobel Prize for Economics, for his work in experimental economics – studying market behaviour using controlled experiments in the laboratory or field. He also describes himself as “what for a couple of centuries was called a liberal, until somehow that term was stolen”, believing that wealth creation comes from giving people the freedom to innovate and discover.
Looking at the field of pensions, his current concern is to warn that the reforms being canvassed, including default options, could have negative unintended consequences. He also remains a firm believer in the notion that pensions should be funded privately and that redistribution programmes should use taxes on consumption rather than income.
JOHN AUTHERS: Why are you a liberal?
VERNON SMITH: It’s basically the classic liberal position from the old Whig party. I’m pretty apolitical and I don’t support candidates. But in the end, countries that are high on creating wealth are also high on these various measures of freedom and openness and competitiveness.
JA: Do you think that default options will have the intended effect of increasing saving? Will people opt for this through inertia?
VS: I think there’s good reason for people’s inertia. It is a consequence of how our brains work – the brain/mind dichotomy. Contrary to the constructivist models of economic theory, most of our actions and decisions do not follow from mindful deliberation.
As Hayek once said: “If we stopped doing everything for which we do not know the reason, or for which we cannot provide a justification... we would probably soon be dead.”
Surveys show that people want to save more than they in fact can do. So maybe you should default them in. But I don’t think anyone knows what the long-term consequences of that will be.
JA: What do you have in mind? Could there be unintended negative consequences?
VS: Surveys indicate that defaults will get people into these savings programmes. But will they pull the money out when they get the chance and buy a Mercedes or whatever? Will this just enable them ultimately to buy bigger toys? We don’t know the answer to these questions.
I think a lot of people will default in and then they won’t bother to go back. But maybe some will go back and use that money to buy large-ticket items. All I’m saying is that I don’t know.
These kinds of [default] programmes have been successful in some companies. But none of them have been going long enough to measure the long term effects.
JA: Could it have consequences for the way fund managers manage money?
VS: I don’t know that we can be sure of what those are. But I can give you some examples. Suppose I want to put money into index funds. An index is computed from the prices of individual stocks. If everyone is putting money into index funds [as would likely be the case in many proposed default options], where do the prices come from? Who’s discovering the prices and determining them?
Index funds just free-ride on the decisions of whoever is buying and selling individual stocks. Suppose this is wildly successful and we have a lot more offerings and then apparently individuals are relying upon others in these programmes to invest for them. So what happens to fund managers’ performance if they’ve got easy money coming in?
This could weaken the process for allocating capital. All I’m trying to do is get people to think about potential negative consequences.
JA: Do you have examples of other public policies that have had unintended consequences for individual behaviour?
VS: Yes. Often, we introduce some changes in policy and implement them and then we find out there are some changes in the world as a result of the policy that we didn’t anticipate. My work has to do with looking at markets and how they might be affected by some kinds of policy. In experiments, you get a chance to see how people react.
The big example that we found was that welfare programmes caused people to structure their family differently. Welfare aid to families provided incentives for male heads to separate, creating female heads of existing and new households.
JA: Do you have any examples involving markets?
VS: Yes. People introduced the policy of incentive penalty rates for peak electricity consumption relative to an off-peak baseline. They were thinking the baseline wasn’t going to change and hoped to reduce peak consumption. In fact, it also caused off-peak consumption to increase allowing the difference between your peak and off-peak consumption to stay within the no-penalty guideline. Similarly for seasonal incentives to reduce summer water consumption: you don’t want people to avoid penalty summer rates by letting their hoses run in the winter.
It’s the same in Florida – if you have an anti-gouging law to keep the price of plywood down after hurricanes, that reduces the incentive to build inventories of plywood. So you have less plywood. Is that what you want? These are the kinds of things that happen in real markets. You have got to look at the longer-term picture.
It has nothing to do with conspiracy or anything like that. It just has to do with incentives and how people behave.
JA: What are your thoughts on how default options should be designed?
VS: I find it very hard to think about how you would invest for someone else. I make investment decisions myself but I would not suggest that all other people do what I do. In my own personal portfolio decisions, I buy very risky stocks and that’s partly because I have a very large pension, and that’s because I’ve been paying into TIAA-CREF [a big pension fund for US teachers] for 50 years, at the maximum rate. That’s a big diversified portfolio that they manage. So why should I buy bonds on my own account?
I buy small companies because I enjoy it. It’s fun, and if I have an investment in a company then I really follow it. If I don’t have an investment in it and I try to get myself to follow it, I don’t. That’s my inertia. I just don’t want to take the time to follow very many companies. But if I’ve got a stake in them, then I do. That’s the way I trick myself into giving them attention.
JA: Do you have any other proposals for raising savings?
VS: I have long favoured a consumption tax rather than an income tax. To me, if people are concerned about the poor you are talking about inadequate consumption. At all levels, you want people to have an incentive to work and also to save. But at the same time, you have to ask what opportunities can you create so that those savings will be intelligently invested? On the other side, you need to open up incentives in business.
JA: How is that relevant to pension saving?
VS: Wealth creation derives entirely from “can do” knowledge specialisation – skill, innovation and its tools. This is a bottom-up process and thrives amidst freedom to innovate and discover. We get students here from Italy and Spain and Germany and I ask them why they are here. They always say: “Opportunities in Europe are limited.” Young people who are ambitious and looking for opportunities will leave. The brain drain is one of the things you get when you make it harder to start businesses. That’s why you have this spectacular turnaround in Ireland.
We don’t want to prejudice the ultimate creation of wealth that underpins all of this by the measures we are taking.
JA: So how would your consumption tax work?
VS: I would make it so that below a base poverty level of consumption, people get transfer payments. If you are below the poverty level, you get a transfer of $1,000, say, and if you save $500 we don’t take it away from you through taxes. At very low welfare levels, people should still have some incentive to build capital. That way you also give people more control over their own individual lives, or at least you are prepared to support that.
JA: And for the rich?
VS: No tax on capital investments; the latter work for us all. Pay a big tax if consumption is high – on yachts or second and third homes.
By making savings deductible from income a progressive income tax becomes a progressive consumption tax, and for redistribution to the poor the tax would become negative – a rebate – below a poverty level. You don’t have to know why people are poor – old age, inadequate skills, earthquakes, floods, bad luck in health or decision making, whatever.
