A cold wind of change is set to blow across Europe

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GERMANY IS starting to cut back the size of the state. Yesterday, the German cabinet approved a new austerity budget with DM30bn (pounds 10bn) in spending cuts, coupled with new environmental taxes to help fund a reduction in company taxation. The most controversial of the measures the German government proposes is not a cut in spending programmes as such, but a cut in the way pension increases will be calculated: for the next four years, pensions will be linked to inflation (currently below 1 per cent) rather than to wages as in the past.

To anyone in Britain, looking at the plans, there will be a sense of deja vu. This last idea - linking pensions to prices rather than earnings - was introduced by Peter Lilly during the 1980s, while some of the other proposed changes, such as a cut in corporation tax rates from 40 per cent to 25 per cent, echo changes made here by governments of both parties. In any case, the plans are still just that, for unlike in Britain where budgets go straight through parliament, in Germany the government's budget is likely to be modified by the legislature. But if the proposals, even in their original form, seem unremarkable to British eyes, they are causing the deepest heart-searching in Germany. Quite simply, they seem to be breaking not one, but two promises.

Promise one was a pledge made by the Social Democrats before last year's election that they would not take money away from pensioners to pay for cuts in company taxation. Now, you could argue that this is not what is actually happening - that the cuts in pensions are needed because of the potential deficit in the social security fund in the next century and that it is environmental taxes that will pay for cuts in company taxation. Nevertheless it looks bad.

More fundamental though, is the breaking of a second pledge, the implicit one that the state will be a reliable funder of pensions and other social services through the next century. Here in Britain we have become accustomed to a certain cynicism about the state's ability to provide adequate funding for social services in general and public pensions in particular. We know that the reason why we have been encouraged by governments of both parties to make private provision for our old age is that the state's provision will be pretty meagre. We may hope we will turn out to be wrong, but we know we would be unwise to bet on the generosity of future voters.

The Germans are different. High taxation is accepted as part of a social contact between taxpayers and tax beneficiaries. Yes, I know that tax evasion is often called a German sport and there are a string of cases where senior bankers and industrialists have done for tax offences. Nevertheless, there is a general acceptance of the contract that in return for paying the taxes - and in particular the social security contributions - they will receive high quality social services and the pensions they have been promised.

The problem is that there is no mathematical way in which those promises can be redeemed. The maths are very simple. The present pay-as-you-go pension schemes rely on each generation of workers paying the pensions of the previous generation. When these schemes were developed in the 1950s and 1960s there were, in most western European countries, roughly seven workers for each pensioner. Now (and again it varies from country to country) there are around four. By 2040, when young people now entering the workforce can expect to retire, there will be between one-and-a-half and two.

Pension systems that were designed on a seven-to-one ratio, creak on a four-to-one ratio, and cannot work on the sort of ratios likely a generation from now.

It is a problem for the whole of Europe and for Japan, but Germany has a particularly adverse outlook as its very low fertility rates (some 1.2 babies per mother), its long pre-work training systems and its relatively early retirement dates mean that the projected deficit of its social security funds will be more than 400 per cent of GDP by 2050.

That won't happen because it cannot happen. Long before then pensions will have to be cut back. The longer these cut-backs are delayed, the more severe they will have to be. The absolutely crucial question is whether it is politically possible to cut back pensions in this way. What is happening in Germany is therefore a test case for virtually the whole of continental Europe: France and Italy have broadly similar prospects too.

The problem for Germany is that this sort of austerity budget is not a one-off, we'll-soon-be-back-to-normal, affair. German (and other European) voters are going to get austerity budget after austerity budget for a generation, as their economies butt into the headwind of adverse demography. Despite reasonable productivity gains, it will be very hard for continental European economies to do much to increase the living standards of their working people, for virtually all the gains from productivity will be mopped up by the costs of caring for the retired folk.

Even in Britain, which will in 2020 have the smallest proportion of over- 65s of any Group of Seven nation bar the US, there will still be a serious problem. But we face a relatively light breeze, compared with the gale into which continental Europe has to sail.

What neither our politicians, nor especially the continental ones, can know is how voters will react to this. A generation of politicians have been brought up on the idea that you attracted voters by promising better public services and better pensions and that the growth of the economy enabled you to do that without unduly increasing the burden of taxation. The favourable demographic factors of most of the post-war period enabled you, more or less, to fulfil those promises.

Now those favourable factors have moved into reverse, forcing politicians on to the back foot. The idea that people will have to pay higher taxes just to maintain a slightly worse level of services and slightly lower pensions is a deeply unattractive proposition to have to sell to voters. Yet that is exactly what continental European politicians will have to do, not just this year in Germany but again and again for another 30 years and more.

I don't know how German voters will react to this mini-dose of hair-shirt politics, but I know that the inexorable mathematics of Europe's ageing population will utterly transform the whole nature of the individual and the state over the next generation. Meanwhile, the reaction to this German budget will be an interesting test case.