Stephen King: This debate is about politics, not economics

The metaphysical punch-up that's taking place between Gordon Brown, the Chancellor of the Exchequer, and Adair Turner, the Chair of the Pensions Commission, is all about the "affordability" of the Commission's state pension plans relative to those already in place.

According to the Chancellor, the Commission's plans, by restoring the link between the basic state pension and wage growth, are simply too expensive. According to Adair Turner, the numbers contained within the Government's plans are simply unrealistic: the "true" cost of the Government's plans will be a lot higher than the Treasury is letting on. Thus the cost "gap" between the Commission's plans and current arrangements is not as big as the Government is claiming.

Ahead of the publication of the Commission's report on Wednesday, it's obviously difficult to know what to make of this intellectual slugfest. The passionate nature of the punch-up, though, reveals an essential truth about the pensions, healthcare and ageing debate. This is a debate about politics, not straightforward economics, a debate about income redistribution rather than simple resource allocation.

Pension arrangements vary hugely from one country to the next. Some countries depend on arrangements made primarily by the public sector. Others are more private-sector based. Some countries run funded pension schemes. Others depend on pay-as-you-go pension schemes, paying for pensions through current taxation.

In the UK's case, we've come to depend on a three-tier system: a basic, pay-as-you-go, system which guarantees a minimum amount of income to prevent the old and infirm from starving or freezing to death: a funded system in either the private or public sector which is invested in assets designed to provide a decent return when people eventually retire, and a voluntary "top-up" funded system for those that feel that the likely income from the first two tiers just isn't up to scratch.

The spat between the Chancellor and Adair Turner really focuses on the first of these tiers. Turner wants to make sure that everyone has access to a "pay-as-you-go" system, indexed according to wage growth. The Chancellor prefers a means-tested system which is indexed according to inflation.

There are two key differences between these approaches. First, a system indexed according to wage growth is more expensive than one linked to inflation - one of the reasons that Margaret Thatcher severed the link to earnings in the early-1980s. A system linked to wage growth effectively means that pensioners will share in an economy's ongoing productivity gains. To reduce the cost of this policy, Lord Turner is suggesting that the retirement age should gradually rise, in line with likely advances in life expectancy.

Second, a means-tested system suffers from moral hazard problems: if you know that you will be bailed out in old age whether or not you've saved in earlier years, then you might as well carry on spending. Under a means-tested system, you know that future taxpayers will be forced to bail you out for your earlier spending indiscretions.

Frankly, though, the pay-as-you-go debate is a sideshow compared with the really big challenges that face ageing societies. Countries with ageing populations - a reflection both of greater longevity and a declining birth rate - eventually find themselves running out of workers. More precisely, the number of people in retirement starts to rise relative to the number of people in work.

Unless output per worker rises unusually quickly, simple arithmetic suggests that, for each hour worked, there will be more mouths to feed, clothe and protect. In other words, the burden on workers - whether in the form of taxes or withdrawn benefits - becomes increasingly painful. And, because of this, workers may react in unhelpful ways - withdrawing their labour through strike action, or emigration to countries where the burden of looking after older generations is lower. Output falls, leading to the beginnings of a vicious cycle.

Until now, countries with ageing populations have managed to avoid these problems more by luck than by good judgement. The main reason has been the impact of the baby boomers. Born in the 1950s and early 1960s, they have provided a windfall gain, boosting the population of working age over the past 30 years or so. Now, though, they are heading toward retirement, creating a windfall burden for the next generation of workers who, relative to the baby boomers, are fewer in number.

The importance of the baby boomers in masking the underlying demographic time-bomb cannot be overstated. In the 1930s, male life expectancy in the United States was around 65, the same as the retirement age. This was no coincidence: the retirement age was deliberately chosen to ensure some insurance for those that lived beyond 65 and, at the same time, some guarantee that society as a whole would not be over-burdened by a large number of - in effect - unemployed people.

How things change. Today, male life expectancy in the United States stands at 78 yet the typical male worker expects to retire at around 60 or 61. Society then has to find a way of supporting that worker in his ever-lengthening dotage. Until recently, the answer has come from recourse to the baby boomers. That arithmetic no longer works.

How do you produce enough output to feed and clothe the workers, their children and, in addition, an ever-increasing number of retirees? If there isn't enough output, the difference between a funded and a pay -as-you-go pension scheme collapses.

The oft-made assumption is that a funded pension scheme is, somehow, safer than the pay-as-you-go alternative. But, in a world where output is insufficiently high, a funded scheme will simply collapse in value when the time comes to spend it. If the fund is held in cash, the damage will be done through higher inflation (in other words, the value of cash will fall relative to the value of goods and services). If the fund is in assets, those assets will have to be sold to the younger - and, of course, now smaller - working generation. And because there are fewer of them, the value of those assets will probably show a sharp decline. That means lower house prices, lower equity prices and, more generally, a period of asset price deflation. Japan's experience over the past 15 years fits this model remarkably well.

The most obvious way to deal with this problem is to boost output. But because governments don't have a magic wand that will automatically deliver higher productivity, more practical steps are required.

For continental Europe, faced with structurally high levels of unemployment, labour market reforms designed to lower the unemployment rate are now essential.

For ageing industrialised nations more generally, the maintenance of liberal market regimes is vital: capital should be allowed to flow to where young labour is plentiful (which is why China and India should be treated more as windfall gains to the Western world than windfall threats) and labour migration should not be allowed to fall victim to draconian immigration laws. For Western workers, the retirement age is bound to rise, and doubtless there will be pressure to work longer hours (sadly, my Blackberry allows me to do exactly that).

Knowing that reforms are necessary does not guarantee, of course, that those reforms will be delivered. Society's preferences are likely to mutate as the average age of the population goes up. Assuming there is no change in the current retirement age, more than 50 per cent of voters in Europe - the UK included - will be pensioners in 25 years' time. Better, therefore, to have the debate now than wait until society's interests lie in milking the remaining workers dry.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com