Poised for vintage performance

QUITE suddenly, in the space of a few months, the world of finance has become aware of the world of demography. Demographers have been worrying about the long-term effects of an ageing population. Financial analysts have been worrying about the long-term effects of government fiscal deficits. But only now are the two beginning to get together and think through the relationship between these two factors. And hardly anyone is also examining the more general consequences of ageing on the economies of the mature developed countries as a whole.

This is particularly an issue for continental European countries. Not only are they ageing faster than, for example, the US or the UK, but they rely more on public sector pay-as-you-go schemes rather than private-sector fully funded provision. And as in general their tax take is already a somewhat higher proportion of GDP, they are closer to the absolute taxation limits.

Of course, no one really knows just where these limits might be, but it is easy to see that the present promises made by governments on pensions cannot be met. As the graph on the left shows, both Italy and Germany will be spending more than one-fifth of GDP on pensions in 15 years' time, and they, plus France and the Netherlands, will be spending more than a quarter by 2030. That would mean that more than half of all public spending would be mopped up by pensions, something which simply is not credible.

This has important implications for such things as the Maastricht convergence criteria, one of which is that public sector debt should not be more than 60 per cent of GDP. But this calculation excludes unfunded pension liabilities, which, as the graph on the right shows, are in many cases much bigger than GDP already. Even Britain has a problem, though not as serious as that of other European countries.

At least people are now talking about the problem, which is perhaps the first step towards doing something about it, although financial markets have not yet started to reflect these unfunded liabilities in national credit ratings. It is implicitly assumed by the markets that as and when taxes need to rise to cover these liabilities, governments will be able to do so. But this comfortable assumption (comfortable for bondholders that is, not taxpayers!) is increasingly being challenged, and challenged not just by the American radical right, but by the British thoughtful centre.

For example, in his recent book The World After Communism, the economist Lord Skidelsky argues that public spending should not be more than 30 per cent of national income - it is about 42 per cent now. And tomorrow a new Demos pamphlet, "Taking tax out of politics", will argue that it should not be more than 40 per cent. Its authors are Sir Douglas Hague, former economic adviser to Margaret Thatcher, and Geoff Mulgan, former adviser to Gordon Brown, which makes the idea about as cross-party as you could get.

These ideas about the appropriate size of the state are becoming the new orthodoxy in Britain and America, but are not yet so generally accepted in continental Europe. Nevertheless, competition between developed-country governments seems likely to force a convergence of tax rates downwards, rather than upwards. In Scandinavia, the region with the largest state sectors in Western Europe, that process has been at work for the past 10 years.

If this line of argument is followed through, there will be a number of consequences for financial markets. Some of these are described in a new paper by Paribas Capital Markets, "An Ageing Europe". Funded pensions schemes will have to expand across continental Europe, as governments will be unable to provide adequate pensions from current taxation. The growth of these pension funds will have a striking impact on companies, with for example, German ones turning much more to equity finance instead of relying heavily on the banks for capital.

Savings ratios, which have declined sharply since the 1960s, will have to rise, but since these "old" economies will have limited needs for the capital, a fair proportion of this savings surplus will be invested in the newly industrialised countries, where investment needs are greater.

Unemployment? It would be nice to think that the shortage of young people will lead to a fall in unemployment on the grounds that the present unemployed will make up for the shortage of young people. Paribas is less sanguine, arguing instead that much of the present unemployment in Europe is structural and therefore the unemployed will not necessarily be sucked back into jobs. On the other hand, job prospects for the elderly will improve, as many employers will seek to use these people's skills. Obviously the greater the extent to which older people can be kept in jobs, the lower the pension burden.

Paribas then looks at the impact of ageing on individual sectors of the commercial world. There will, for example, be continued growth in financial services as people buy pensions and other savings products. Entertainment will increasingly be targeted at the elderly, a sharp contrast with the present (but maybe good news for the Stones as they move into their seventies?). Private sector health care will obviously continue to expand. In the stores sector, Paribas believes, superstores will be threatened and the prosperous elderly will want to buy an element of service with their products.

Finally Paribas also looks at the consequences for the various countries: how France, Germany and particularly Italy face a time-bomb; and how the UK, quite aside from having larger private pension assets than those three countries put together, will also have one of the highest support ratios in Europe (the highest number of people of working age relative to the number of dependents).

What the paper does not, however, do is to look at the impact that these very different age profiles will have on relative economic performance. There is surely a conclusion here which is glaring everyone in the face, but which will nevertheless seem rather odd to many Britons.

It is this. Given Britain's more favourable demographics, and given its private pension system, it will be quite difficult for this country not to perform rather better than the rest of Europe over the next 25 years. The probability, surely, is that we will have, by 2020, somewhat higher living standards than France or Germany and much higher ones than Italy.

There are other reasons to believe that this may be so: the fact that the UK economy is heavily involved in the sectors which are likely to grow, including financial services and entertainment, but leaving these aside, demography alone should ensure a better relative performance.

This is a conclusion which many people here will not like. A generation accustomed to a relatively poor economic performance inevitably finds it hard to adjust to one where the performance is relatively good.

But the economic pecking order does change over time. Look at Japan: the fastest-growing developed economy of the 1960s, 1970s and 1980s has in the 1990s become the slowest. It is also, incidentally, becoming the "oldest" of the G7 countries. That is surely no coincidence.