The force assaulting the euro

The Economist

Free exchange

Europe’s ageing population poses a long-term threat to monetary union

Jun 6th 2015 |

THE euro area has been doing better of late: growth of 0.4% in the first quarter (1.6% on an annualised basis) was the strongest in the two-year recovery; unemployment has fallen to 11.1%, its lowest in three years; and inflation is positive again. There has even been a surge of hope that Greece’s membership of the currency may yet be preserved. But even if a deal is stitched together to keep Greece in, the euro will soon face a broader crisis. The slow growth and strained government finances of recent years will soon be dramatically amplified by demography. And the member facing the most severe onslaught is not a small Mediterranean country but Germany, the euro area’s muscleman.

The economic impact of an ageing population is initially positive but ultimately negative. The big generation born after the second world war contributed for many years to higher growth by making the workforce larger, both in absolute terms and relative to the population as a whole. But as baby-boomers retire, they are being replaced by smaller generations born when fertility was much lower. Unless there are offsetting improvements in productivity or retirement ages rise sharply, that will pull down potential growth, since there will be fewer people available to work. The shift is determined by births that occurred many years ago and medical advances that are stretching longevity, and is therefore inexorable. An influx of young migrants can only temper it, since the native population is inevitably much bigger than the number of new arrivals.

The fiscal impact of an ageing population also has two phases. In the first, public budgets enjoy a bonus as the rising number of workers swells tax receipts while the relatively smaller number of the old restrains the cost of pensions. But as the baby-boomers retire the bonus turns into a penalty. There are fewer people in the working-age bracket to pay taxes while the growing number of retirees pushes up age-related spending in two main ways. More people begin drawing public pensions, and their health care, which is mainly provided by governments, becomes more expensive. Although expenditure on education tends to fall, the savings are relatively small.

America’s post-war baby boom began earlier than Europe’s, right after the war. Its birth rate peaked in the late 1950s. That has meant that the first of its baby-boomers are already retiring. But because its fertility has stayed close to the replacement rate (just over two children per woman) and immigration has been relatively high, its working-age population continues to grow.

In contrast, Europe’s baby boom only really got under way in the 1950s and peaked in the mid-1960s, so Europe is only now entering the negative phase. But Europe’s baby boom was weaker than the American version and its fertility rate fell further and faster after it. It dropped well below the replacement rate in the 1970s and has stayed especially low in southern Europe and Germany. (In Britain and France it has risen back to American levels in recent years.)

That means the effect of the inflection will be especially profound in the euro zone. New projections recently published by the European Commission spell out both the magnitude and the imminence of the shift. Between 2013 (the base year for the forecasts) and 2030 the euro zone’s working-age population will decline by 6% (see chart). The decline is likely to be particularly pronounced in Germany, where the pool of potential workers will shrink by 13%. The fall in France, in contrast, will be only 1% and Britain will experience a small increase, of 2%.

As the working-age population falls, the ranks of pensioners will be growing. That double squeeze pushes up the old-age dependency ratio (defined as those aged 65 or more relative to 20-to 64-year-olds). In the euro area as a whole the ratio moves up from 32% in 2013 to 45% in 2030. The demographic change is especially intense in Germany, where the number of pensioners will rise by 5m (an increase of 30%) even as the working-age population falls by over 6m. That will drive up its dependency ratio from 34% to 52% in 2030—the highest in Europe apart from the small Baltic state of Latvia.

No rest for the childless

These adverse demographic influences do not automatically condemn the euro-zone economy to even more sluggish growth. In principle higher productivity growth could compensate for the declining number of workers, which by the mid-2020s will be pulling down Germany’s GDP growth by around 0.7 percentage points a year, according to the Commission’s projections. However, even before the financial crisis, productivity growth in the euro area had slowed. It has been nugatory during the euro crisis of the past four years. For it to recover even to its previously disappointing rate of 1% a year would be an achievement in itself.

The most obvious response to an ageing population is for older people to carry on working and for pensions to be paid later in their lives. Changes made in Italy in 2011, for example, yanked up the retirement age. This could potentially raise the labour supply sharply as more 50- and 60-somethings stay in the workforce. Similarly, in or out of the euro zone, Greece needs to tackle early retirement. Even with such reforms, however, the zone will struggle to grow at a reasonable rate in the next 15 years. That will make it tough to tackle the big private- as well as public-debt overhangs that afflict many of its member states, leaving them vulnerable to further setbacks.

The fact that ageing will be especially pronounced in Germany matters because of its weight in the monetary union. The resilience of its economy bolstered the euro area during the crisis. But demography will weaken the zone’s biggest economy. Indeed the new projections show Britain (assuming it stays together and remains in the European Union) supplanting Germany as the most populous country in the EU by 2050. The ageing of its population will hobble the euro area’s strongman.

http://www.economist.com/news/finance-and-economics/21653660-europes-ageing-population-poses-long-term-threat-monetary-union-force