Democratic Representation and Economic Policy Rules in an Ageing Society

Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECBEumoniamaster – Institutional and Political Higher EducationVilla Morghen, Florence, 28 September 2006

The topic I would like to address today concerns the way in which population ageing affects the ability of democratic institutions to represent the interests of their citizens over time. The issue is very high on the agenda in the economic policy debate in many countries, including Italy.

In general terms, the problem derives from the fact that certain economic policy decisions taken on a democratic basis – i.e., taking into account the specific interests prevailing at that time -- may subsequently prove to be no longer representative of the general interest, because certain basic parameters on which the initial decision was based have meanwhile changed. This problem is well known in the economic literature analysing policy decisions taken under uncertainty and imperfect information^[1]. The solution to this time inconsistency problem is to adopt rules or institutions capable of at least partially limiting the use of discretion in decision-making.

This type of solution is not substantially different from that of the protection of minorities in a democracy. The objective is to prevent certain classes of citizens from being systematically penalized by decisions taken by the majority (the so-called dictatorship of the majority). Indeed, constitutional law aims at preventing easy change of the ground rules of the democratic game, which might benefit in a systematic way only certain parties.

I would like to examine three policy instruments which can be used by democratically representative institutions to offload the burden of paying for goods from which the current majority gains an immediate benefit onto the shoulders of future generations: the inflation rate, the public debt, and the pension system. The use of these policy instruments creates a problem of representation of future generations, who may be penalised.

The three policy instruments have certain aspects in common.

First of all, these instruments often produce opposite effects in the short and medium-long term. Therefore, they are generally used to benefit the current generation, whose interests are well represented in current democratic institutions, while penalising the next generation, which is not yet represented. Moreover, these instruments are not easily reversible. Once you start using tools such as inflation, the public debt, or pension systems in a distortionary manner, it is not easy to backtrack and to adopt measures going in the opposite direction which can nullify the initial effect or at least partially compensate those who have been damaged by them. In fact, those who benefit from such measures tend to consider them as “natural rights”, even though they are, in fact, taken without proper consideration of the interests of those who are not yet represented in democratic institutions and who will have to pay the bill. Finally, these instruments are typically used in a non-transparent way. The medium-term effects that ought to discourage their use are not always clearly spelled out when the decisions are made. The absence of an independent assessment or of stringent monitoring by the media contributes to their lack of transparency.

These problems do not concern economic policy alone; they relate to many other aspects of democratic life, such as the environment, urban planning and so forth.^[2]

Population ageing exacerbates the problem because it increases the cost offloaded onto future generations. The concept of “no taxation without representation” which is at the origin of liberal democracies risks being violated.

The argument that I would like to put forward is that population ageing -- a problem shared by most European countries -- demands that greater attention be focused on the need to ensure that inter-generational interests are properly represented. Such an objective can be implemented by strengthening certain constraints on the use of discretion in the democratic institutions' decision-making processes.

Monetary policy influences economic decisions via the interest rate. An expansionary monetary policy, by reducing the real interest rate, prompts agents to bring forward their consumption and investment spending, funding such spending through debt. Over time, however, such a policy tends to push inflation up, penalising savers and those who have not been able to correctly foresee the rise in prices -- typically, the less well-off.

Unpredictable shifts in inflation can lead to a major redistribution of income across generations and, within each generation, between creditors and debtors. This redistribution is both opaque and undemocratic, because it takes place quite some time after the policy decision is made, often without those who suffer from its consequences being informed about it or being given a chance to voice their opinion.

Some calculations show that the high inflation rate recorded in Italy in the 1970s caused a redistribution of income in favour of the public sector and firms, and to the detriment of households, slashing the latter’s spending power by some 3.8% of total consumption.^[3]

The experiences of the 1970s and 1980s and economic analysis have prompted governments to separate monetary policy from the other economic policies which are more closely linked to the political-electoral cycle.^[4] Nowadays, monetary policy in every industrially advanced country is decided by independent central banks whose primary objective is to ensure price stability. This makes it possible to prevent the inflation rate from being used to redistribute resources across generations and social classes.

Central banks, while operating independently, are accountable for safeguarding the general interest. The general interests are represented not through a democratically elected institution, but by a specific mandate given to an independent authority accountable to the general public.

Budget policy is an area which, typically, falls within the competence of the political authority that directly represents the people's will, in other words, the Parliament and the Government. Budget policy can nevertheless have a very important redistributive impact across generations. In particular, the public debt shifts onto the shoulders of future generations (which do not yet enjoy institutional representation) the burden of funding public spending in excess of revenue.^[5]

The negative impact on future generations may be partially compensated for by the benefits that these generations may gain from past higher public spending (for instance, if a large part of such expenditure went into profitable investments), and if the population increases in such a way that the burden of repaying the debt can be shared out over an increasing number of people. Yet this compensation effect is reduced if, as happens in most industrially advanced countries, the level of public spending over GDP is already very high and if the population is ageing. The rise in public debt entails a heavy increase in the burden for future generations especially in countries where the debt level itself is already very high.

The example of Italy in the 1980s is a case in point. In 1980 the public debt accounted for some 57% of GDP. In 1994, in just over 10 years, the public debt more than doubled, rising to 121.5% of GDP. A European Commission calculation suggests that if the public debt is to be brought down to the 60% level within the next 45 years, a structural budget surplus of 3% of GDP will be necessary every single year till then. This means that the public finance policy pursued by democratically elected Parliaments and Governments in the 1980s has offloaded onto the average Italian citizen an additional burden (in the form of higher taxes or fewer public services) of up to €1,000 a year for the next 45 years.^[6] We may well ask ourselves whether the services provided by the public expenditure infrastructures, health, education, security and so justify this additional burden for the next few decades.

A further problem is that it is difficult to give up benefits that have been decided on in the past but that are not financially sustainable. For instance, the Italian budget deficit in 2006 is largely due to an increase in primary public spending (before interest) of 3% of GDP compared with the year 2000 (rising from 41% of GDP to 44%), which has not been funded by a parallel increase in the tax burden. If the aim is not to increase taxation -- indeed if many people wish to bring it down -- then it is necessary to unwind the increase in spending of the past few years and to return to the (sustainable) spending levels of the year 2000. This is however considered by many as a social disaster, as if the level of public expenditure prevailing in 2000 was socially unacceptable.

In economic policy, as in medicine, prevention is better than cure. Given that it is difficult to give up "acquired rights", even when the latter are not financially sustainable, it is preferable to enforce budget constraints designed to prevent policies likely to increase the public debt.

The Maastricht Treaty imposes a binding constraint on the public debt, setting its ceiling at 3% of GDP, and requiring a decrease in the debt at a satisfactory rate when that debt exceeds a given threshold. This constraint is not just necessary in order to participate to monetary union, as the euro area, it is also, and above all, a constraint of “good government” to prevent that the burden of excessive debt policies is offloaded onto the future generations.

Ageing population and negative demographics may jeopardize the financial and political sustainability of pension systems. With people living longer and the birth rate dropping, there are only three ways of ensuring that pension systems are funded: i) a cut in pension benefits; ii) an increase in contributions; or iii) raising of the retirement age.^[7]

To avoid having to adopt one of these three solutions, democratically representative institutions in many countries have so far decided to offload the cost onto future generations via the public debt. Such a method is sustainable as long as the population increases. As long as children outnumbered their parents, they would shoulder the burden of funding their parents' long-term pensions. But with the drop in the birth rate, that room for manoeuvre no longer exists. The only way for parents' increasingly long-term pensions to be paid today is by increasing their children’s contributions, in other words, by raising their children’s taxes.^[8]

That is what the future seems to hold for many European countries. Due to the ageing population, and in the absence of any pension system reform, tax revenue is going to have to rise by 2.9% of GDP in Germany, by 4.3% in France, and by 1.3% in Italy between now and 2050 – assuming that there is no further increase in the average life expectancy.^[9]

An increase in contributions and taxes for the younger generations triggers a series of economic distortions, in particular increases labour costs and reduces the incentive for longer term contracts. The recent deterioration in the youth employment situation can be partly blamed on the excessive contribution burden, due to the inability to tailor the burden to pension benefits for each generation. Indeed, it is no coincidence that in countries where the pension system has been equitably reformed in inter-generational terms youth employment is not an issue.

In most countries there are still no constitutional constraints which would link in a quasi automatic way benefits and the retirement age to contributions and to the average life expectancy, so as to prevent one generation from being paid its pension by the next generation, with benefits that the latter generation could not itself hope to enjoy. For instance such mechanism could foresee that working life is adjusted in a quasi automatic way to life expectancy. Yet in view of the financial and political turmoil we will be facing a few years from now, we may in fact have to resort in the future to some kind of legal constraint à la Maastricht Treaty in order to resolve the pension problem.

The ageing of population and demographic trends in advanced countries are putting a new challenge to the democratic representation of institutions responsible for economic policies. The solution is not simple, but may require new constitutional rules that limit discretion in decision-making. To be sure, never has it been more important for those that have the responsibility to represent public interest to ensure that these interests are represented not only at a given moment in time but consistently, across generations.

Source: European Commission, AMECO database.

Source: European Commission (2006): The impact of ageing on public expenditure: projections for the EU25 Member States on pensions, health care, long-term care, education and unemployment transfers (2004-2050), report prepared by the Economic Policy Committee and DG ECFIN.

Source: European Commission (2006): The impact of ageing on public expenditure: projections for the EU25 Member States on pensions, health care, long-term care, education and unemployment transfers (2004-2050), report prepared by the Economic Policy Committee and DG ECFIN.

Source: European Commission (2006): The impact of ageing on public expenditure: projections for the EU25 Member States on pensions, health care, long-term care, education and unemployment transfers (2004-2050), report prepared by the Economic Policy Committee and DG ECFIN. Figures in millions of inhabitants.

Source: OECD.

Source: European Commission: Stability and Convergence programmes (SCP) updated to 2005/06.

* Incomplete figures: certain items of expenditure were not available when the SCPs were completed.