Eurosclerosis - the role of demography and welfare state

The blame game for the crisis in Euro zone goes on. This has become yet another opportunity for closet free-marketers (who had been briefly silenced in the aftermath of the sub-prime crisis) to question the sustainability of the European model of social democracy (with its generous vacations, early retirements, national health care systems and extensive welfare benefits) and proclaim the relative superiority of American capitalism. This triumphalism comes despite America facing massive problems of much the same kind and magnitude as Europe - unsustainable fiscal and current account deficits, burgeoning debt stocks, aging populations, frozen credit markets and anemic economic growth environment. Further, on critical areas like limiting job losses and cushioning against the adverse impacts of the depp recession, Europe appears to have done far better than the US

Amidst all the explanations for the problems that afflict the Eurozone, one cannot but help not notice certain similarities between it and rest of the advanced economies, mainly the United States. Despite the slight variations in the depths of their recessions, fundamentally all have couple of underlying socio-economic characteristics - one, the steep increase in debt burdens in recent years, and second, the aging demographic profile of national populations which significantly distorts the financial dynamics of the generous existing welfare system.

The massive debt stocks and persistent deficits (internal and external) coupled with recession will ensure that the share of public debt relative to the GDP will continue to rise. The aging demographic profile will only increase the upward pressures on government expenditures. In the circumstances, there are only two options - either cut down on other expenditures or increase taxes. However, the magnitude of the deficits are so large that merely tinkering with conventional expenditure cutting areas like defense and welfare will yield limited results. This leaves governments with no alternative but to raise taxes steeply apart from indulging in all the conventional expenditure control measures.

However, as Peter Boone and Simon Johnson show with the example of Ireland, such interventions to both cut expenditures and raise taxes come with considerable costs and even threatens to drag the economy into a deeper hole. Despite the tough fiscal austerity measures (by slashing public sector spending and freezing wages for government employees) and tax increases since spring 2009, the European Commission estimates that Ireland will have one of the highest budget deficits in the world at 11.7% of GDP in 2010. Such countries face fiscal problems from both directions - "when you cut spending you also lose tax revenues from people who earned incomes from that money" and "the newly unemployed seek benefits, so Ireland’s spending cuts in one category are partly offset by more spending in another".

Adverse demographics in the shape of an aging population and resultant fiscal strains to support the same level of welfare benefits forms the second leg of the problems facing these countries, with the Eurozone countries being the worst affected. A series of excellent graphics captures the true extent of the demographic challenge and the resultant pension problems facing advanced economies.

The first graphic best captures the gravity of pension crisis facing the advanced economies - the numbers of workers supporting a retired person is projected to decline dramatically. In the 1950s while there were around 7 workers on average for every retiree in OECD countries, it had fallen to 4 to 1 by 2010, and is projected to fall to just 2.2 to 1 in 2040.



The graphic on legal retirement age and effective age of exit for the active population, 2002-2007, shows that France stands out among all its OECD partners.



As a corollary, the amount of time people spend in retirement is over 20 in most OECD countries, with France naturally topping, as the graphic below of the estimated years in retirement, by sex, 2007 shows.



Forecast indicate that the cost of public pension systems will keep rising. Whereas, in 2007 public spending on pensions accounted for 10% of GDP in the European Union, it is estimated to rise to 12.5% by 2060.



Public transfers form a disconcertingly large share of people's retirement incomes in most OECD countries.



As a reflection of these growing problems, a recent Times op-ed reported that gross public social expenditures in the European Union increased from 16% of GDP in 1980 to 21% in 2005, compared with 15.9% in the United States. In France, the figure now is 31%, the highest in Europe, with state pensions making up more than 44% of the total and health care, 30%. Further, only half the people above 50 work, compared to 7 out of 10 in others like Sweden and Switzerland, and the legal retirement age is 60. The French state pension system today is running a deficit of 11 billion euros, or about $13.8 billion; by 2050, it will be 103 billion euros, or $129.5 billion, about 2.6 percent of projected economic output.

The US too faces much the same problems with its rapidly aging population. As Bruce Bartlett explains, pointing to a Census Bureau report, that an aging population may make it even harder, politically speaking, to cut benefits like Social Security. The census estimates that while 27.1% of the population is currently under age 20, 59.9% is between 20 and 64, and 13% is 65 or older, by 2020, the under-65 share will fall by 3.1% and the 65 and over share will rise to 16.1% of the population. In raw numbers, the number of those 65 or over will rise by 14.5 million persons.

Update 1 (26/5/2010)
In response to the crisis, many European countries have announced fiscal austerity plans, mainly freezing or cutting public-sector pay, increasing retirement ages and reversing temporary tax breaks and other cushions that were encouraged in 2008 and 2009 to help beat back the worst recession in decades. These spending cuts when fiscal expansion is the need of the hour have raised fears about the possibility of these economies being dragged into a deeper recession.

Italy announced that it would cut its budget deficit to below 3% of GDP by 2012, from 5.3% last year, through cuts to public spending, and reducing the costs of politics and public administration, while pledging a more concentrated crackdown on tax evasion and on people fraudulently collecting disability pensions. Pay for civil servants would be frozen for three years, top-level civil servants’ wages would be cut and the retirement of state employees would be delayed. It however has said there would be no new taxes or raising of existing taxes.

Greece has already announced increasing the broader retirement age to 65 and cutting public salaries to bring the deficit down from the current 13.6% GDP to less than 3% in 2014. Spain has announced pay cuts of about 5% for civil servants — and 15% for government ministers — as well as other measures totaling 15 billion euros, besides reversing a previous decision to increase pensions next year and scrapping a subsidy of 2,500 euros for new parents. Portugal has announced plans to cut its deficit faster than planned, to 4.6% of GDP next year from 9.4% last year. They have already declared on tax increases and cuts in public-sector wages and corporate subsidies.

The new British government has declared that it would push through £6 billion ($8.65 billion) in spending cuts in an effort to convince skittish markets that the new government led by David Cameron was committed to fiscal restraint. More detailed cutbacks are expected in a new budget next month.