The ageing problem: the ECB’s views
Speech by José Manuel González-Páramo, Member of the Executive Board of the ECB
Brussels, 31 March 2006
Ladies and gentlemen,
Peter Heller started this afternoon’s session by asking “can Europe afford to grow old?” On a simple level, the answer is that Europe is growing old and that we have to afford it. On the basis of current projections, the old-age dependency ratio is expected to more than double from around 25% today to more than 50% by the middle of the century. And the overall dependency ratio is projected to increase from around 50% today, to 80% in fifty years time. Even if there would be a dramatic turnaround in birth rates starting tomorrow, which I certainly don’t expect, Europe will have to cope with much higher dependency ratios in the coming decades.
2. The implications of ageing
What impact will this have on the European economy? At the present juncture all analyses and evaluations are surrounded by a large degree of uncertainty. Having said this, what implications will ageing have? In terms of the real economy it means, ceteris paribus, that we will have lower trend growth. Mechanical calculations using growth accounting frameworks suggest that, if utilisation and productivity growth rates were to remain at current levels, the reduction in trend real GDP growth would be in the order of 1% per annum. More realistic projections like those contained in the latest Economic Policy Committee Report are along the same lines.
From a central banking perspective, I would also point to some of the consequences that ageing could have on financial markets. At least in theory, according to the life-cycle pattern of saving, the young tend to borrow against their human capital, the middle-aged build up savings, and the old draw down their savings to finance consumption during retirement. As these groups differ in size over time, this is likely to affect the balance between saving and investment. This would then have implications for international capital flows between “younger” and “older countries”. It could also contribute to a lowering of the natural or equilibrium rate of interest as a growing number of people save for retirement. Many other scenarios - featured by a deteriorating investment-savings balance - point in the same direction.
Ageing may also influence the structure of savings portfolios. As any driving instructor will tell you, the older we are the more risk averse we become. And this is true not just on the highway but also with regard to investment choices. As populations grow older, we may observe a shift in demand in favour of less risky assets, although any such trend may be limited by the diversification of savings through financial intermediaries.
And the importance of such intermediaries in our financial landscape is also likely to grow. Already, euro area households are increasingly channelling funds towards pension funds and insurance corporations and less towards traditional banks. Given the current regulatory and accounting frameworks governing such intermediaries, this means that the demand for high quality, highly liquid and possibly also inflation indexed paper is likely to increase. And indeed some European governments are already responding to this increased demand with more long-dated and/or indexed bond issues.
This brings me to the public finances, which are of course acutely affected by demographic trends. Thanks to many hours of work by the Economic Policy Committee and its ageing working group, we now have updated and detailed projections for age-relating spending in EU Member States. And on the whole the EPC’s report does not make for particularly pleasant reading. Clearly, public finances in many countries are still on an unsustainable long-run path.
3. Policy prescriptions
What are the policy responses? I believe that many convincing answers to this question have already been provided, but let me stress four areas where I consider policy action to be important.
Firstly, we should of course be trying, as far as possible, to limit the increase in the dependency ratio. There are essentially three factors at play here: fertility, mortality and immigration. Obviously we cannot aim to increase mortality. On the contrary longevity is usually considered a good thing, at least by those who experience it! But we can encourage fertility by having child-friendly welfare and working arrangements. And immigration may also help to reduce dependency ratios in some countries.
Secondly, action is needed to increase labour utilisation and productivity and thereby raise potential growth rates - or at least stem their decline. To this end, as we say again and again, the Lisbon agenda of structural reforms must be vigorously pursued. Participation rates, in particular those of women and older workers, need to increase. The latter probably also means changing certain attitudes to skills and experience; as the saying goes, “there’s many a good tune played by an old fiddle”.
Thirdly, and this is something we also repeat quite often, countries must achieve sound budgetary positions. In this they should be supported by a rigorous implementation of the Stability and Growth Pact. Excessive deficits should be corrected as a matter of urgency and swift progress should be made towards medium-term budgetary objectives. Otherwise the current window of opportunity to build in fiscal room for manoeuvre before the fiscal burden of ageing becomes more acute will be wasted.
And fourthly, many countries still need to undertake reforms to their social welfare systems, in particular their pension systems, to make them sustainable in the face of ageing. In this regard, the difference between the long-term projections prepared by the EPC five years ago and those produced now illustrates how reforms, in particular pension reforms introducing fully funded pillars, have been helpful in some countries; even though we should of course interpret long-term projections cautiously.
4. Concluding remarks
Let me finish by pointing to a few conclusions from my experience and from what I have heard today. The first is that policy prescriptions to address the problem of ageing are largely known. The challenge is to carry these policies out as many of them are understandably unpopular to voters. This makes it all the more important to explain the need for action and build consensus among the general public.
It is also clear that no single policy action or sub-group of actions alone is sufficient to meet the challenges posed by ageing. Action is required on many fronts in the context of a comprehensive and credible strategy. This makes me sceptical of approaches based on trading-off, for example, fiscal consolidation and structural reform.
Finally, what about monetary policy? Well obviously monetary policy is not a tool that was designed to address the ageing problem. But monetary policy can and does make a positive contribution by providing a stable, non-inflationary macroeconomic environment, which is supportive of growth. And to deliver this, central bankers will increasingly need to monitor the impact of ageing, on the real economy, on financial markets, and on the public finances. We will need to be aware of the impact that ageing may be having on important variables for monetary policy such as the natural or equilibrium rate of interest, or the relative strength of the various channels through which monetary policy affects economic activity and prices. The action that governments take to address the ageing problem will not only determine whether or not Europe can afford to grow old, it will also make the central banker’s task of delivering price stability that little bit easier, or more difficult in the years to come.