Mr. Osis persists in his misunderstanding of what ‘capital’ is (link to previous blog). According to him, the 1st level of the Latvian pension system entails savings and alleged accumulation of capital. This time Mr. Osis shows some ‘empirical evidence’ to back his words - namely a report from the VSAA (State Social Security Agency), which says that Mr. Osis’ “pension capital is 164683.94 Ls”. His article (in Latvian) is here.

This little debate is becoming a bit surreal. If Mr. Osis claims that my notions of what constitutes savings, investment, and capital are “a messy construction of economic terms”, I can only refer him to a principles level textbook. Based on what Mr. Osis has written so far, I am not sure he has a sufficient grasp of these concepts. For example, consider the following paragraph from his latest article [translation mine]:

“As an additional argument Mr. Dombrovskis in his critical composition states that the Latvian pension system is based on the so-called pay-as-you-go (PAYG) principle. In Latvian, it means that we all regularly pay for something, like taxes from regular incomes. I don’t know why Mr. Dombrovskis mentions this to deny the existence of pension capital. Of course, we all pay taxes from our incomes, including the social tax, which, indeed, can be interpreted as PAYG. But this absolutely doesn’t explain anything about the pension capital and does not reveal its essence. It is the same as, for example, you pay your operator for talking on a mobile phone (PAYG), but it has only technical connection with the mobile phone itself (capital). But from economics of finance point of view there is no connection whatsoever. This superficial approach to economic and financial concepts and their mutual interrelationships can lead to absurd conclusions and complete misunderstanding of the topic under consideration [emphasis mine].”

I have to admit that, at first, I couldn’t understand what Mr. Osis was trying to say, in spite of re-reading this paragraph several times. Except, of course, the fact that the last sentence is probably addressed to me. Taxes? Mobile phones??! But then I began thinking like this. What if someone has no idea what a pay-as-you-go pension system is? What is the first thing this someone does? Right… And so I punched “PAYG” into Google and inspected the first page of results… Do it yourself and you will see that it explains quite a lot. What can I say? A superficial approach can lead to a lot of misunderstanding, indeed. Mr. Osis has a great point there.

I guess I should not have presumed that just saying “PAYG pension system” will mean everybody will understand what I am talking about. So, just to be on the safe side. This here should take care of the terminology. This wikipedia article on pensions and World Bank’s primer on pension reform are good starting points.

Now that the confusion with a PAYG pension system has been (hopefully) cleared, lets proceed to the empirical part of Mr. Osis argument – the VSAA “pension capital”. As I said earlier, Latvian pension system is a ‘pay-as-you-go’ or unfunded one. Within a broad class of PAYG systems, it can be classified as a ‘notional account’ system (see previous reference). Such a system usually maintains individual accounts where contributions are recorded and (sometimes) a notional ‘interest’ is credited every year. However, these balances are IMAGINARY (hence the word ‘notional’) in the sense that they do not represent funds or investments. ‘Notional accounts’ system is a mere actuarial benefit formula, which is subject to the budget constraint imposed by the availability of social tax revenue. Again, there is no savings, investment and, therefore, no capital in this system. If the tax revenue (unexpectedly) falls, then the participants of this system will find out the difference between ‘imaginary’ and ‘real’ the hard way. I am terribly sorry to be the one to break such news on Mr Osis (and possibly many others), but that ‘pension capital’ that they think they have is not exactly what they think it is.

The bottom-line is this. The mere act of saying that a pumpkin is a coach, and mice are horses will not, unfortunately, make the pumpkin a viable means of transportation. However, this may have really pretty real effects when residents of the fantasy land will (inevitably) wake up to the harsh reality. Same with the pension system. It was rather unfortunate for the lawmakers to call pensions ‘capital’. If even Mr. Osis managed to get himself so thoroughly confused, what about all the ordinary pensioners? What will be their reaction when their imagined coach will turn into what it really is – a pumpkin?