Defusing the Demographic Timebomb – Are we Being Too Pessimistic About the Future of Pensions?

People are living longer. This is good news – but you could be forgiven for not noticing. The inevitable rise in the ratio of elderly to working-age adults has generally been viewed as a looming shortage of labour, with some authors talking of a ‘demographic timebomb’ buried in the early 21^st century. But according to Kevin Gardiner, speaking at a CEPR/Royal Economic Society public discussion meeting on Thursday 3 February, this view is far too pessimistic.

Gardiner noted that the ultimate determinant of average living standards and of real pensions is the rate at which the economy can grow. This is turn depends on the amount and utilisation of labour and capital resources available and the pace of technical progress. But many analyses of the pension crises do not provide even a cursory examination of these themes.

Gardiner argued that there is no necessary shortage of labour facing the UK or continental Europe. Plausible changes in participation and unemployment rates can deliver a rising supply of labour, even in Euroland, where the population is projected to decline. This is before taking account of possible increases in retirement ages and working hours, let alone extra capital input or technical progress (see below).

Specifically, US-style levels of labour utilisation would permit existing levels of European pensions to be financed at lower average tax rates than at present. Current schemes may be suitable.

In the UK, economic dependency (carefully defined) has been higher on at least three occasions in the not-so-distant past (1981, 1986 and 1991) than would be the case in 2030 on unchanged participation and unemployment rates. Such episodes were of course brief, but their existence suggests that the territory ahead, even on the pessimistic assumption of ‘no change’ in labour utilisation, is far from uncharted.

What is more, there is no obvious constraint on the supply of capital. In the UK the capital stock has been growing steadily at recent investment rates. The investment ratio may be trending higher; in which case the pace of capital accumulation could accelerate.

More important than both the supply of labour and capital is the prospect of continuing growth in total factor productivity (TFP), or technical progress. Historically, TFP growth seems to have accounted for most output growth in the UK. If past trends continue and are supplemented by extra labour and capital input, per capita GDP growth could accelerate over the next three decades. The likelihood of an aggregate supply constraint biting on GDP and average living standards in the UK is slim. The same is likely to be true of Euroland.

Having produced the output that will sustain pensions, society has to decide how to facilitate the transfer payments from workers to pensioners. There are two administrative models, the ‘pay as you go’ system and the ‘funded’ system. There are strong political reasons for believing that decentralised privately-run funded arrangements are preferable, but it is difficult to refute the conjecture that the economic differences between the two methods is small.

In particular, the past performance of the securities markets can shed little light on the ultimate worth of pensions for the ageing population. The value of securities accumulated within funded schemes will be influenced by the future rate of economic growth, but also by prospective real interest rates. Unfortunately, the ageing process itself tells us little about the likely course of the latter, despite the likelihood of an increase in personal discount rates, which occurs as time becomes more precious.

Gardiner concluded that policy-makers should place less emphasis on measures designed to raise savings: a higher aggregate saving ratio is not necessary to fund future pensions, and could even prove counterproductive if unaccompanied by measures encouraging higher investment. Instead, policy should focus on improving labour market flexibility and fostering economic growth. Rather than focus on the possibility of a future shortage of labour, European politicians should focus on making bigger inroads into today’s excess supply.

Of course, if the Euroland pension ‘crisis’ is avoidable, there is no need to postpone UK accession to the single currency on this score.

Note for Editors: Kevin Gardiner was speaking at a public meeting on ‘Defusing the Pensions Timebomb: What are the Policy Options?’, organised by CEPR and the Royal Economic Society (RES) and supported by Morgan Stanley Dean Witter. Gardiner’s presentation drew on ‘Defusing the Demographic Timebomb’, a report written while he was working for Morgan Stanley Dean Witter and published in October 1999.

For Further Information: contact Kevin Gardiner on 020 7286-1586 (fax: 020 7286-3549); or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 0468-661095 (email: romesh@compuserve.com).