Pension reform: Revitalising old Europe

Date: 15/03/03

Adverse demographics demand longer working lives and Swedish-style pension reforms

DONALD RUMSFELD'S scornful dismissal of France and Germany as “old Europe” was plainly intended to cut the two countries down to size. But the American defence secretary's jibe struck a raw nerve across the continent, including the new Europe to the east that he seems to prefer. For Europe, new and old, is ageing fast.

Latest projections from the United Nations highlight the scale of the demographic changes ahead. The age of the median German today is 40, but by 2050, it will be 47; in France, the median age will rise from 38 to 45. Old Europe is getting older. But ageing is even more striking in central and eastern Europe. Over the same period in Poland, the median age will rise from 35 to 49; in Hungary, from 38 to 50. In marked contrast, the typical American today is 35; by 2050, he will be only 40.

Population ageing happens when birth rates fall and people live longer. In developing countries - whose median age is also rising sharply, albeit from a much lower base - ageing is welcome because it can give a demographic bonus to growth. The labour force increases rapidly because of past high fertility, and the number of dependants grows more slowly because of declining birth rates. Workers save and invest more because they have fewer children to raise and can expect to live longer. This demographic windfall may have accounted for as much as a third of the East Asian economic miracle between 1965 and 1990.

In developed economies, population ageing is less welcome from an economic and fiscal perspective. Unlike developing countries, which age from the bottom up because of a falling birth rate, rich countries age from the middle, adding old people with fewer workers to support them, and even fewer children to join the workforce. So they face both a shortfall in growth and a ballooning fiscal burden. The problem is more serious in Europe than in America, because birth rates have been lower.

In the 15 members of the European Union the working-age population will start to fall after 2010. Unless there is an offsetting rise in productivity or employment rates, GDP growth will suffer because there will be fewer workers. The European Commission forecasts that annual growth will decline from around 2% to 1% by 2040. Growth in GDP per head declines less sharply because populations start to decline, but living standards will still be 20% lower in 2050 than if there had been no ageing.

At the same time, the fiscal burden on the diminishing number of worker-bees will rise as more people turn into pensioner drones. Across Europe, the dependency ratio of older people (aged 65 and over) to those of working age (15-64) will double from one-to-four to one-to-two by 2050. This will push up public spending on pensions and health care. According to the commission, such spending in the EU will rise by five-to-eight percentage points of GDP by 2040.

One response is to try to fix the demographics. But this is hard. The age structure of the population bears the imprint of decades of below-replacement fertility: the working-age population in the EU is expected to fall by 40m over the next 50 years. At the same time post-war baby boomers are on the eve of retirement: the number of people aged 65 or over is expected to rise by 40m. So apparent antidotes to ageing, such as immigration of younger workers, would require huge inflows to make a real dent on dependency ratios. This remedy is anyway politically unfeasible, not least since it might lead to runaway population growth, as the UN spelt out three years ago. Trying to raise birth rates is difficult because people's fertility does not seem to respond much to fiscal incentives.

Europe's politically painful remedies

The best way forward, therefore, is to find economic and fiscal solutions. But they have to be realistic. Higher productivity growth could offset the effect of falling numbers of workers. However, there is less reason to expect a productivity spurt than a decline from an ageing population, because older people tend to be less entrepreneurial. Another way to prepare for a future fiscal burden is to run down public debt now. But the experience of the past few years has shown this strategy to be politically flimsy: budget surpluses have been raided to pay for tax cuts or higher public spending.

The top priority in Europe is to raise employment, both by increasing participation rates among the working-age population and by deferring retirement. At present, the overall employment rate in the working-age population of the EU is 64%. This contrasts with 73% in the United States and even higher rates in Denmark, Sweden and the Netherlands. Three years ago, European leaders committed themselves at the Lisbon summit to big increases in employment rates by 2010 - especially of older workers. Next week they will meet to review what progress has been made. The answer is: not much. They need to get cracking with reforms to pension systems and labour markets, rather than just talking about them.

Achieving this does not require the EU to abandon its cherished social model for the American one. But European leaders may need to look east. Countries such as Poland and Latvia have pushed through radical pension reforms based on a Swedish template, which will reduce the fiscal pressures from population ageing and encourage longer working lives.

For all their quarrels over Iraq, ageing European countries share a vital interest in international security. Investments in the developing world - boosted by funds from reformed pensions - offer a way to make future prosperity less vulnerable to the effects of ageing. The opportunity is the greater because of the demographic bonus to growth in many developing countries. But if money is to flow in earnest, more must be done for investors - whether they live in old or new Europe.

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