Can Europe Afford to Grow Old?

1. Can Europe Afford to Grow Old? Peter S. Heller International Monetary Fund March 31, 2006

2. The answer of course is yes, it has no choice! • The more relevant questions are: • Can Europe afford its current expectations as to the standard of living of the elderly as the population ages and of the role of the public sector in supporting that standard of living? NO! • If not, then what policies can improve the way Europe ages in terms of achieving satisfactory economic and social outcomes

3. Key Challenges in Achieving a Satisfactory Outcome • How can governments achieve a fiscally sustainable position consistent with a satisfactory intergenera- tional income distribution and supportive of growth? • How to facilitate behavioral change and adjustment in expectations of households? • How to move to higher GDP level and growth trajectory? • How to address sources of inefficiency and market failure that increase the cost of medical care? • When must governments act to exploit windows of opportunity? • Are there additional Europe-specific challenges?

4. Achieving a Fiscally Sustainable Position • The Aging Working Group Projections are a useful starting point for discussion: Will not here seek to dissect the assumptions • Illustrate substantial sustainability challenges faced particularly by many of the smaller European economies • IMF perspective: they are probably optimistic in a number of ways, so that the fiscal sustainability challenge is probably greater than portrayed • They leave unstated the policy changes that would be required to achieve assumed labor force participation and employment rates

5. Achieving a Fiscally Sustainable Position • Level of unfunded implicit debt is far too large: fiscal adjustment is inevitable • Will inevitably require a blend of • Fiscal adjustment—raising taxes or limiting expenditure (including downsizing of infrastructure) • Benefit rationalization • Structural reforms • Avoid “dead end” solutions, viz., reliance only on • full primary gap adjustment: political economy challenge • annual fiscal deficit adjustment: much more costly • deferred structural reforms to pension system: political economy challenge

6. Achieving a Fiscally Sustainable Position • Level of unfunded implicit debt is far too large: fiscal adjustment is inevitable • Its more than just demographics! Fiscal policy stance must ensure resiliency and robustness in face of numerous potential uncertainties: • Demographic uncertainties • Reaction functions of households in terms of savings behavior • Interest rate movements in globalized, aging world • Climate change effects (sea level rise and storm surges; low probability high consequence events re Gulf Stream shift; sectoral shocks from change in temperature and precipitation) • Other unknowable shocks (e.g., avian flu pandemic)

7. Achieving a Fiscally Sustainable Position • Level of unfunded implicit debt is far too large: fiscal adjustment is inevitable • Its more than just demographics! Fiscal policy must ensure resiliency and robustness in face of numerous uncertainties • The cure should not be worse than the disease! Seek policies that are supportive of growth; consider the macroeconomic effects of alternative gap-closing approaches • Raising payroll or income tax rates would be deleterious to growth • Consider households savings/investment reactions to policy choices

8. Achieving a Fiscally Sustainable Position • Level of unfunded implicit debt is far too large: fiscal adjustment is inevitable • Its more than just demographics! Fiscal policy must ensure resiliency and robustness in face of numerous uncertainties • The cure should not be worse than the disease! Seek policies that are supportive of growth; consider the macroeconomic effects of alternative gap closing approaches • The solution should not compromise basic intergenerational social insurance pact—preventing poverty among the elderly • The policy solution must at least ensure a zero or first pillar that provides a basic pension that is above poverty level; • A solution that excessively reduces the replacement rate below an acceptable social norm will fail

9. Achieving a Fiscally Sustainable Position • Level of unfunded implicit debt is far too large: fiscal adjustment is inevitable • Its more than just demographics! Fiscal policy must ensure resiliency and robustness in face of numerous uncertainties • The cure should not be worse than the disease! Seek policies that are supportive of growth; consider the macroeconomic effects of alternative gap closing approaches • The solution should not compromise basic intergenerational social insurance pact—preventing poverty among the elderly • Achieving fiscal sustainability is only one part of the challenge of making “aging affordable for Europe” • Leaves open the question of standard of living of elderly • Quality of public services being delivered • Competitiveness of economy

10. The challenge for governments:Facilitate behavioral change and adjustment in individual expectations • The work/retirement balance: the need for retirement age to rise pari passu with improvements in life expectancy • Ensuring incentives exist for higher labor force participation by older age groups/females • Encourage business toward greater flexibility in employment and wage policy in adapting to elderly work force • Limiting individual expectations as to what medical care can be publicly guaranteed and financed • Encourage greater risk pooling in private long-term care insurance • Strengthened financial education and financial awareness • Foster provision of new financial products (longevity bonds, alternative annuity instruments; investment-advice embedded financial instruments; increased use of hedging strategies) and raise quality of savings

11. Fostering a higher GDP level and growth trajectory? • The fall in fertility rates, with limited migration, implies stabilized if not falling population and a shrinking of the labor force: higher incomes will thus derive from increased efficiency; greater labor force participation, employment, and hours worked; and robust productivity growth • An aging labor force can be a source of high productivity, but its not to be taken for granted. Will require adaptation by business and governments • Higher incomes will facilitate addressing needs of an aged population, but will not solve distributional issues • Significant premium to be attached to rendering Europe attractive for foreign investment and able to compete at the high end in globalized product and service markets • Recognize that achieving greater competitiveness and flexibility may be necessary simply to realize assumed productivity growth assumptions: • Possibility of unanticipated shocks: climate change; enhanced competitiveness of China and India at high end; energy shocks

12. Lisbon Agenda plus • Efforts to enhance the functioning of labor markets will not be effective in the absence of measures to open product and services markets to greater competition • Enhance integration of national financial markets in order to facilitate flow of capital across national boundaries in Europe—to effectively raise quality of savings • (single payment system; securities settlement system; contract law harmonization; development of market in asset-backed securities) • Greater regulatory harmonization • Achieve harmonization of tax laws and social insurance portability • Facilitate labor mobility • Provide opportunities for well-targeted immigration • Strengthened investments in human capital and R&D

13. How to address sources of inefficiency and market failure that increase the cost of medical care? • In principle, higher spending on health, if well spent, efficiently produced, and productive, should not be seen as a problem • But serious challenges relate to the operation of the medical care sector—market failure, issues of financing, and inefficiencies: • Well-recognized sources of market failure: asymmetric information; moral hazard associated with third party financing; monopoly power among providers; adverse selection; also, in some countries, lack of competition for medical services • In some countries, absence of global budgetary rationing mechanism to limit access to treatment in situations where the cost of treatment exceeds the likely benefits (inadequate “value for money” • Pressures for rapid growth in medical care costs (income elasticity of demand more than one; pressures associated with aging of population; pressures for high technology adoption in medical care equipment and pharmaceuticals; lack of testing for relative effectiveness of new high cost drugs; supplier incentives to promote more care) require comprehensive global budget rationing, particularly with public financing. • Without limits on extent of private insurance for co pays and deductibles, the result can either be further pressure for sustained growth of medical care costs or concerns on equitable access.

14. When must governments act to exploit windows of opportunity? • The evidence is clear from sustainability analysis: Acting early reduces the cost of adjustment: • Equally, the political economy of the measures involved argues for early adjustment: an aging electorate will prove more resistant to cutbacks in benefits and more receptive to increased taxes on working population • Delays may push public debt levels to a point where financial markets begin to raise risk premium on government borrowing—create vicious cycle in terms of fiscal dynamic

15. Are their additional Europe-specific challenges? • Dealing with substantial differences in the size of imbalances across European countries • The potential fiscal imbalances are very large for many European countries—more than Euro 10 or 25 average • What will be consequences of particular countries falling further behind in their capacity to address fiscal challenges of aging? • Potential for vicious circle—high tax rates, weak benefits leading to out-migration that further shrinks the size of the tax base

16. Euro-specific challenges • Dealing with substantial differences in the size of fiscal imbalances across European countries • How to address pressures for cross-border mobility for medical care, in response to differential availability of services? Issues of eligibility? Cross-subsidization? • Opportunities of globalization • Outsourcing • Nontraded goods • Immigration • Potential risks: energy markets • Fiscal Space from inverted yield curve? • Reconciliation of global current account imbalances • Will new projections be used for SGP benchmarking, despite their optimistic bias? • Role of asset sales—sale of patrimony?