UK avoids the global demographic time-bomb

"In all the large seven economies except the UK, the 'dependency' ratio of elderly people to the population of working age is projected to double in the next 40 to 50 years. "
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The Independent Online
Occasionally, an economic study is published that illuminates well-known aspects of economic performance, and also has the capacity to surprise. This applies to the study on the budgetary effects of ageing populations published last week by the OECD.* If this study is even remotely right, the UK will have a huge - and until now hidden - economic advantage over other countries in the next few decades. And Japan, the miracle economy of the post-war period, could be in deep trouble long after the present deflationary shock is safely negotiated.

Economists have been aware for some time that most developed economies will face a serious problem in the next few decades as the demographic balance of their populations begins to change. The ageing of the populations, combined with quite generous provisions for pension payments, and the increasing health care costs for old people, have been threatening to produce a serious deterioration in budget balances in the first part of the next century unless offsetting action is taken soon. The OECD study published last week emphasised just how large these problems could be.

In all the large seven economies except the UK, the "dependency" ratio of elderly people to the population of working age is projected to double in the next 40 to 50 years. Of course, these population trends are not yet entirely determined - they could be affected slightly by changes in immigration, or in the birth rate. But the vast majority of the working population in the year 2015 has already been born, so the OECD's figures should not be far wrong.

In most countries, the number of young people is projected to remain roughly constant, but the population bulge created by the "baby boomers" will gradually pass from working age into retirement. Hence the elderly dependency ratio will rise sharply in all countries. It will peak at about 60 to 70 per cent in Japan, Germany, Italy and France, but will rise to only 40-50 per cent in the US, Canada and the UK. From present levels, the rise is projected to be much less pronounced in the UK than in any other economy.

As a result of these demographic changes, and the public sector pension plans now in place, the OECD estimates that public sector pension expenditure will rise sharply. Most countries offer a basic retirement provision for all citizens, regardless of contribution records, and also fund pensions for public servants out of general taxation. Many also offer top-up pensions, supposedly related to contribution records, but which are actually funded on a pay-as-you-go basis.

This multifaceted provision will mean that as the population ages in the next few decades, pension burdens on government budgets will rise to 5 to 8 per cent of GDP in the US, Canada and the UK, and to 15-20 per cent of GDP in Japan, Germany, France and Italy. This is despite assuming that all countries unify their retirement age at 65.

Because per capita needs for medical treatment rise dramatically above the age of 65, total health costs will also rise markedly in all economies as the population ages. Meanwhile, education spending will decline only slightly. The upshot will be that, on unchanged policies, government spending will rise far more rapidly than GDP, which will in itself be held down by a decline in the working population.

Tax revenue will therefore lag behind spending and, in most countries, budget deficits and government debt ratios will have a very strong tendency to rise, as is shown in the table.

Japan's debt/GDP ratio could rise from 13 per cent now to 289 per cent by 2030, while the US and continental Europe could see their debt ratios at 90 to120 per cent of GDP. These are quite alarming numbers, and the earlier that offsetting action is taken - to reduce pension commitments, or cut the budget deficit in other areas - the better.

The OECD points out that an immediate and permanent improvement in the budget balance of 1 per cent of GDP would reduce debt ratios in 2030 by 40 to 55 per cent of GDP.

If on the other hand governments choose to offset the demographic problem only as it occurs, this would require budgetary action equal to 5 to 9 per cent of GDP by 2030. The reason is that the longer governments wait to take offsetting action, the more debt is incurred, and the higher are interest payments on a permanent basis.Among individual countries, two conclusions stand out. First, the Japanese medium-term fiscal problem is far larger than generally assumed, especially in the financial markets, which remain unduly impressed by today's very low ratio of net public debt to GDP.

If the OECD is right, the present tax and spending regime in Japan would lead to an explosion in public debt and deficits in the next 40 years, taking the budget deficit up to 20 per cent of GDP and the debt ratio up to 289 per cent of GDP by 2030.

This explains why the Ministry of Finance is so reluctant to ease fiscal policy now; and it may also explain the high private savings ratio in Japan, since the present working population may correctly suspect that the public sector will not be able to deliver the pensions they have been promised. Therefore, individuals must make provision for themselves, just in case. And since the whole nation is thinking the same way, the outcome is that Japan builds up investment overseas - future claims on foreigners - and runs a structural current account surplus now.

It remains to be seen whether foreigners will deliver the real investment returns Japan will be demanding in 30 to 40 years' time, or will find ways (for example, inflation and devaluation) to avoid paying back the real resources borrowed from Japan.

If I were a Japanese 40-year-old, I would choose to invest more in the emerging countries of Asia - the Japans of the next century - than in the old developed countries. In the latter group, the demographic structure will be broadly the same in 2030 as that in Japan, and the transfer of resources back to Japan will create even more of a burden on the dwindling working population of the US and Europe. Even if these over-burdened workers do not default on their obligations to Japan, the pressures to inflate and devalue would be great.

Second, the UK, along with Canada, stands out as a country that will not suffer from these problems in the decades ahead. Partly because of less worrying demographic trends, and partly because public pension provision was so heavily curtailed by the Thatcher government (especially by linking pension upratings to prices, not wages, which has a gigantic effect on the problem in the long term), unchanged policies in the UK would imply that government welfare spending should actually increase less rapidly than tax revenue over the next few decades. The OECD simulations show the UK paying off the national debt by 2030!

Of course, this will not happen. But while other countries are sweating blood to reduce pension commitments and/or to finance them through higher taxation, the UK could have the luxury of deciding when and how far to reduce the tax burden. Too good to be true, perhaps. But certainly Britain's relative position will be very comfortable, and that will be an advantage in the international economic battles ahead.

*OECD Economic Outlook, June 1995

OECD simulations of fiscal balances

Budget deficit Public debt/

GDP ratio

(% of GDP) 1995 2000 2030 1995 2000 2030

USA -1.8 -2.2 -9.3 38 39 94

Japan -4.1 -2.0 -19.8 13 24 289

Germany -2.3 -1.9 -9.4 46 44 93

France -5.0 -1.6 -8.5 36 41 88

Italy -7.8 -3.5 -12.8 121 107 126

UK -4.2 0.1 1.0 47 40 -9

Canada -3.7 -0.1 -1.1 64 54 -13