Macroeconomic implications of demographic developments in the euro area

Angela Maddaloni, Alberto Musso, Philipp Rother, Thomas Westermann, Melanie Ward-Warmedinger

13th Economic Conference, Dubrovnik, 28 June 2007

Disclaimer: Any views expressed are only the authors own and do not necessarily reflect the views of the ECB or the Eurosystem

The current situation

From The Economist, 14 June 2007: Europe is fast becoming a barren, ageing, enfeebled place. Vast numbers of old people, [..] will be looked after, or neglected, by too few economically active adults, supplemented by restless crowds of migrants. The combination of low fertility, longer life and mass immigration will put intolerable pressure on public health, pensions and social services, leading (probably) to upheaval. Maybe this looks a bit gloomy, but
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The current situation

Available projections suggest that all Western countries face the prospect of population ageing The problem is even more pronounced in the euro area, although there are considerable differences across countries concerning the pace of ageing Important consequences for economic growth, labour markets, public finances and possibly financial markets

Overview
Look at the impact of population ageing for:
Economic growth

Labour markets
Public finances Financial markets

Impact on growth - demographic projections

Notwithstanding the high uncertainty surrounding population projections, working age population growth is projected to turn negative after 2010
2.0 working age population growth

1.5

United States

1.0

0.5

0.0

-0.5

euro area

-1.0 1950-55 1960-65 1970-75 1980-85 1990-95 2000-05 2010-15 2020-25 2030-35 2040-45
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Impact on growth - demographic projections

Compared to the US, euro area dependency ratio is growing much faster. After 2050 every third person will be older than 64
60 55 50 45 40 35 30 25 20 15 10 5 0 United States euro area old age dependency ratio

1950

1960

1970

1980

1990

2000

2010

2020

2030

2040

2050
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Impact on growth demographic projections

The net migration rate is expected to fall up to 2010 and thereafter to stabilise in the euro area
5 Net migration rate (1,000 population)

4 United States 3

2 euro area

1 1995-00 2010-15 2025-30 2040-45

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Impact on growth - backward

In the euro area the contribution of demographic factors to growth decreased since 1980, reflecting increasing dependency ratio and a decline in labour productivity linked to ageing
Euro area growth accounting

7 6 5 4 3 2 1 0 -1 -2 1965 1970 1975 1980

W orking age population contribution Labour productivity contribution Labour utilisation contribution Real GDP growth

1985

1990

1995

2000
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Impact on growth - backward

Working age population growth contributed to real GDP growth in the US more than twice than in the euro area
U S Growth Accounting

7 6 5 4 3 2 1 0 -1 -2 1965 1970

W orking age population contribution Labour productivity contribution Labour utilisation contribution Real GDP growth

1975

1980

1985

1990

1995

2000
9

Impact on growth forward-scenario 1

Assuming the labour productivity and labour utilisation evolve on average as in the past, there will be a negative impact on euro area growth
Euro Area Growth Accounting

7 6 5 4 3 2 1 0 -1 -2 1965 1975 1985

W orking age population contribution Labour productivity contribution Labour utilisation contribution Real GDP growth

1995

2005

2015

2025

2035

2045
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Impact on growth forward-scenario 1

Same scenario for the US
U S Growth Accounting

7 6 5 4 3 2 1 0 -1 -2 1965

W orking age population contribution Labour productivity contribution Labour utilisation contribution Real GDP growth

1975

1985

1995

2005

2015

2025

2035

2045

11

Impact on growth forward-scenario 2

Assuming the labour productivity and labour utilisation grow in line with more optimistic assumptions, still there will be a negative impact on euro area growth
W orking age population contribution Labour productivity contribution Labour utilisation contribution Real GDP growth

7 6 5 4 3 2 1 0 -1 -2 1965

1975

1985

1995

2005

2015

2025

2035

2045
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Impact on growth forward-scenario 2

Same scenario for the US
U S Growth Accounting 7 6 5 4 3 2 1 0 -1 -2 1965 1975 1985 1995 2005 2015 2025 2035 2045

W orking age population contribution Labour productivity contribution Labour utilisation contribution Real GDP growth

13

Overview
Go through the impact on:
Economic growth

Labour markets
Public finance Financial markets What are the options for reforms?
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Labour markets: current situation

Increase labour market participation, employment, productivity: there is significant potential for female participation
%
80 70 60 50 40 30 20 10 0

Euro area average

Female participation rate

um gi l Be

m er G

y an

e ec e r G

n ai p S

e nc a Fr

d an l Ire

Ita

ly m xe u L

g ur o b

s nd a l er th e N

ri st u A

l ga u t r Po

d an l in

Source: Eurostat

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Labour markets: current situation

and for an increased participation of 55-64 years old
% 60 50 40 30 20 10 0
l Be m giu Ge ny a rm e ec e Gr ain p S F ce n ra nd a l Ire ly Ita ds al rg ria t n g u s a u rl bo rtu e A o m h P et xe u N L F nd a l in

55-64 participation rate euro area average

Source: Eurostat
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Reform needs: labour markets

Reduce disincentives to enter work

interplay of taxes and benefits, early retirement schemes

Encourage female labour market entry

increase flexibility of working hours and provision of childcare services

Encourage workers to remain at work later in life

encourage policies of gradual exit from work, part-time work, increases in statutory retirement age

Invest in quality of education, research and development, increase lifelong learning and tackle old age discrimination

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Reform needs: labour markets

The stabilisation of the old-age dependency ratios through migration alone is unlikely, due to the large number of migrants that would be required The EC states that using migration to fully compensate the impact of demographic ageing on the labor market is not a realistic option.

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Overview
Go through the impact on:
Economic growth

Labour markets
Public finances Financial markets What are the options for reforms?
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Impact on public finances

The most important expenditure effects arise from public pension systems and health and long-term care The estimated fiscal impact of the increase in pension expenditures (from different sources) find a cumulative increase in pension expenditure of more than 5 pp of GDP for most euro area countries, with pressure rising rapidly after 2010 (for some countries [GR, PT] up to 10 pp). Looking at the outstanding stock of pension debt, it can be estimated an incremental implicit pension liability of close to 50% of GDP for the four largest euro area countries.
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Impact on public finances

Offsetting effects through unemployment and education expenditure are small and uncertain The EPC/European Commission projections may still turn out too low (e.g. favourable assumptions re. labour productivity) Recent projections by the OECD point to a much more gloomy scenario, especially concerning the cost increases of public spending on health and long-term care.

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Reform options: public finances

Major reform needs in public pension systems and health care and longterm care arrangements:

Parametric reform of conventional pay-as-you-go pension systems necessary, but most likely insufficient Systemic pension reform: shift part of pension financing to funded arrangements and reduce exposure to demographic risks
One option: notional defined contribution (PAYG) system combined with funded pillar

Health care: raise efficiency through setting the right incentives for all participating parties (insurers, providers, patients)
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Overview
Go through the impact on:
Economic growth

Labour markets
Public finance Financial markets What are the options for reforms?
23

Impact on financial markets

Impact on prices and quantities due to changes in savings patterns and savings allocations of people belonging to different generations Changes in financial structures linked to ongoing pension reforms
Workers are required to save more and contribute to funded pension arrangements

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Impact on financial markets

Possible changes in savings patterns are based on the idea that wealth follows a life-cycle pattern; moreover risk tolerance may change with age
1 1 1 1 1 0 current situation 0 0 0 16 20 24 28 32 36 40 44 48 age
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wealth future (2030)

52

56

60

64

68

72

76

80

Impact on financial markets

Theoretical and empirical analysis suggests that a meltdown is unlikely

Forward-looking simulations results (usually based on closedeconomy assumptions)

models suggest that current workers will earn returns around 60 basis points below historical norm (given the assumptions in the models, this would represent an upper bound)

Empirical studies report ambiguous results

results are different across countries, which would imply that the relationship is affected by other fundamental factors

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Impact on financial markets

Will there be an asset meltdown? Probably not, but there could be an impact on prices:
people may change their saving and investment behaviour (and invest more in financial assets) especially if the benefits of public pension schemes are significantly reduced international capital flows could help to smooth imbalances in domestic capital markets (for all kind of assets?)

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Impact on financial markets: housing

housing wealth as % of disposable income in the euro area
500 450 400 350 300 250 200 150 100 50 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 financial wealth housing wealth

Source: ECB estimates based on national data

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Impact on financial markets: housing

A significant portion of households income is invested in housing
the relationship between house prices and ageing remain largely an open question; difficult to disentangle the effect of age from other characteristics (income, marital status, education)

Recent developments in some countries (US, UK but also most of euro area countries) suggest that households may treat real estate as a source of portfolio diversification
may be risky: a future house prices meltdown?

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Impact on financial markets: the retirement industry

Euro area households have invested their private savings more via financial intermediaries (particularly retirement industry)
70 60 50 40 30 20 10 0 Belgium France Germany Italy Netherlands
% of savings to institutions in 1990 % savings to institutions in 2005

Source: Eurosystem, as a % of total financial assets

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Impact on financial markets: the retirement industry

Role played by institutional investors is expected to grow and this may have a number of implications and possibly an impact on corporate governance
120

The retirement savings industry

Pension funds assets, as % of GDP, 2004

100

80

60

40

20

0
Belgium Germany Italy J apan Netherlands S weden UK US

Source: OECD

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Impact on financial markets: the retirement industry

Likely increase in savings for retirement over the next decades
savings need to be invested and later on withdrawn to finance consumption of elderly

Portfolio allocation of pension funds likely to exert significant pressures on financial markets
possible shifts towards less risky assets as people become older?

The extent of the impact is likely to depend on the financial structure and in particular on the social security arrangements
if countries in continental Europe shift more strongly towards funded systems, financial asset prices could in theory show more pronounced swings related to demographic changes

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Impact on financial markets: the retirement industry

Shift from defined benefits to defined contributions plans
portfolio choices will be more aligned with individuals preferences

Revised industry regulations place more emphasis on risk management

need to increase the supply of products to hedge against interest rate and inflation risk
long-dated bonds inflation-linked products financial innovation

Instruments to hedge against longevity risks are more problematic to develop

annuity reverse mortgages

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Conclusions
Scenario analysis shows that projected demographic trends imply a decline in average GDP growth in the euro area to around 1% from 2020 to 2050
It is important to implement the European Employment Guidelines to mitigate the impact of population ageing

Reforms of pension systems and health care arrangements are needed to counteract pressures on public expenditures
Impact on financial markets will derive from changes in portfolio sizes/allocations, the likely increase in the role of financial intermediaries and the related adjustment in the supply of some financial instruments

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