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Get Four
|  | JANUARY 23, 2006
Natascha Gewaltig How Europe Can Age GracefullyIts graying population will put economic pressure on the euro zone soon. What's needed: the political will to implement reforms nowWill the graying of Europe be its economic undoing? In coming decades, a key challenge for countries in the euro zone -- those European nations that use the euro as their common currency -- is posed by an aging population. Even if labor participation rates rise and more women take jobs, economies will depend on immigration to sustain economic growth and fund pension-system liabilities. The next four years provide a window of opportunity for government to implement crucial changes before the demographic shift moves into high gear. Low fertility rates and an increase in life expectancy will lead to a change in the structure of the euro zone population over the coming decades. Demographic estimates from the European Commission (EC) show that much of the increase in life expectancy will be due to a lower mortality rate in the older age brackets. That means that the average age of the population will increase, as the number of citizens older than 65 rises in relation to the working-age population. CRIMPED LABOR SUPPLY. The share of the working-age population (15 to 64) will fall from around 66.9% in 2004 to just 56% in 2050. At the same time, the share of the population older than 65 will increase to 30% from 17%. This development will have several effects. Foremost, the labor supply will decrease over the next few decades. The labor shortage will lead to an increase in wages and a likely attempt to substitute capital for labor. Companies will need to find less labor-intensive production mechanisms as the availability of labor, especially in narrow fields of expertise, diminishes. As a result, the capital/labor ratio may rise, as will labor productivity and gross domestic product per capita. WOMEN TO THE RESCUE? However, as the EC points out, some simulations suggest that the positive effect on economic growth of expanding the capital stock around each worker will be marginal compared with the projected drop in labor supply. Even if the euro zone economies are able to post a 14% rise in the capital-labor ratio, productivity would only increase by 3.3% per year until 2050, assuming a constant population structure. So a greater increase in productivity will be needed to compensate for the loss in output resulting from a fall in the working-age population. Still, the EC estimates that potential growth of the euro zone economy, as gauged by GDP, will decrease to only around 1% in the long term as a result of the aging population. One key issue for these projections: whether female labor participation rates increase, which would at least partially offset the effect of a decline in labor supply. Germany, for example, had a female participation rate of just under 60% in 2004, according to data from the Organization for Economic Cooperation & Development (OECD). This compares to rates of 65.4% in the U.S. and 66.6% in Britain. Participation rates in France and Italy are even lower than in Germany. For the euro zone as a whole, the female employment rate was 56.5% in 2003, and the EU commission suggests that this could rise to 64.6% by 2050. TAX PRESSURES. At the same time, the employment rates of older workers in the age bracket of 55 to 64 will have to be lifted from the 37.4% in 2003. High unemployment in major euro zone countries has meant that early retirement has become almost the norm. The demographic changes will mean that this is no longer a feasible option for the overall economy. Nevertheless, a rising female participation rate will not be sufficient to compensate for the expected decline in the workforce over the period, so immigration will also have to play an increasingly important role. As the commission has pointed out, it's very important to ensure that the skill structure of migrants matches labor market needs. At the moment, unemployment rates among immigrants tend to be higher than those of natives in many EU countries, and better integration remains a key challenge. The impact of these demographic changes on the budgetary situation will be important for financial markets. For one, the demographic changes will lead to a sharp increase in pension spending and other age-related expenditure. Without structural reforms, this would lead to a marked increase in taxes and social security contributions, which will also have an impact on GDP growth. VICIOUS CYCLE. A rise in labor taxes to finance the additional cost could cause unemployment, and the decline in net wages could also have a further negative impact on labor supply. The OECD stresses that raising taxes and levies to finance pensions reduces the total amount of physical capital that can be accumulated via the impact on aftertax income and associated availability of funds for private investment. The necessary tax increases will have a negative impact on productivity and wage levels. A privatization of pension schemes, on the other hand, could more than double the long-run ratio of physical capital to labor, raising long-run wages by around 25%. Indeed, some studies even suggest that the current pay-as-you-go (PAYG) pension schemes have a negative impact on family formation, and thus have contributed to the problem of the aging population. NO TIME TO WASTE. Still, relatively favorable demographic developments over the next 4 to 5 years mean the period until 2011 is a window of opportunity for governments to prepare their pension systems and labor markets for the upcoming challenges. Radical changes and reforms of the PAYG pension schemes in key countries will be necessary. Despite the life-expectancy increase, the entry level for pension schemes has remained widely unchanged -- but this will have to be increased for the plans to remain sustainable. Nevertheless, the time spent in retirement is likely to increase in the long run, all else being equal, and the change in dependency ratios will make the current PAYG system unsustainable. Pension levels will have to be lowered, and private-pension provisions will need to become more important. If policymakers exert the political will to implement these changes now, the euro zone may weather the coming demographic shifts more easily.  Gewaltig is director of European economics for Action Economics
BW MALL
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