'Tis against some men's principle to pay interest,
and seems against others' interest to pay the principal.
– Benjamin Franklin
FOR A CONTINENT following the trajectory of the Great Depression, Europe exudes a surprising calm. In politics, no new phoenix is rising from the ashes of past policies. And in the media, the crisis plays to a weary audience. Lacking the heroes, villains and global relevance of the American debate, and the naked assertions of power that the crisis has encouraged in China, Europe is snoozing.
Complacency is a mistake. The countries most affected may be small and the losses largely on paper, but Europe is missing its last chance to change its economic culture and individuals' behaviour before a much bigger crisis hits: a pension crisis. With more than A$6 trillion in loans, guarantees and direct aid given to banks in the past year, European governments are stretched like bungee cords. Yet The Economist predicts that the coming pension deficit will involve figures up to ten times that size.
While the current crisis renders the future of some private pension funds uncertain, and new debts diminish the capacity of states to meet their pension commitments, the systemic problems long predate it. Neither public policy nor private savings have adjusted to greater life spans. When Bismarck created the aged pension, in 1889, you had to be seventy to qualify – well above the average life expectancy. In 2009 Europeans live far longer but qualify for the pension earlier. The average retirement age for men is below sixty in Belgium, France, Hungary and Italy, and millions more aspire to early retirement.
This seeming social progress sits uneasily with the shrinking ratio of workers to retirees, and rising unemployment rates. Today's generosity may be tomorrow's fiscal nightmare in a region where public pensions can be up to three times as generous as Australia's. Even before the postwar baby boom is added to the bill, pensions are already costing more than 14 per cent of GDP in some Western European countries. With A$5 trillion of private pensions funds ‘up in flames' – as the OECD delicately puts it – in the past year, pensioners are likely to demand even more of politicians in the future.
Twenty years of patchy and incremental pension reforms have not prepared European pension systems to meet these demands. If anything, close observation reveals a repeat of the patterns that generated the sub-prime crisis: a failure of government to keep up with a changed economic landscape, allowing systemic risk to develop; a culture of trying to squeeze too much from a financial system, generating economic shocks; and the misuse of other people's money. The difference is that when the pension crisis unfolds, governments will have little fiscal ammunition left to fire at the problem.
Even if governments can agree to continue an aggressive monetary and fiscal policy for a number of years and then correctly time their transition to more conventional policies, European leaders will struggle to win political acceptance for the tough debt-repayment plans that may give them a chance to tackle the pension problem. However, other potential disasters – like the collapse of a car-industry pension fund alongside a parent company – may conspire to send pensions policy in the other direction.
To guard against this, European governments must start the unenviable task of pursuing cultural change and more radical pension-policy reform, while also managing the recession. The cultural issues will be the hardest to address, because legislation alone cannot solve them. Europe has become a continent of modern-day Marie Antoinettes, funding lifestyles with credit cards, asset bubbles and loans denominated in foreign currencies instead of hard work. Europe's public sector unions reinforce this culture in their united belief that no one should have to sacrifice their ‘rights' to relatively early retirement and generous pensions. Even the well-off – and market-oriented – staff of the European Central Bank are striking over proposed reforms.
The best thing would be for government leaders to convince Europeans that they need to lower their expectations, that they must accept pain in the next economic upswing to reduce long-term difficulties. But with confidence already low and attention distracted by the current crisis, it is easy for politicians to delay this discussion. Predictably, citizens are not clamouring for such tough-love approaches. Indeed, because many stand to gain at the expense of their children, they have strong incentives to stay silent or punish those who act tough. Younger generations, meanwhile, are focused on more immediate and fundamental matters, like getting out of insecure temporary jobs, and do not see beyond the immediate future, let alone save for it.
I might not even have a job in two months. Why do I care what I might get when I am sixty-five?
That's why I pay tax – so the government will think about these issues for me.
– Adele Vanthournhout, 31, Belgium
IN THEORY, THE EUROPEAN Union exists to think about seemingly intractable big-picture issues like pensions on behalf of Adele Vanthournhout and her peers. Yet the EU is absent from this debate, providing only a toothless secretariat, the Committee of European Insurance and Occupational Pensions Supervisors, to monitor market developments. This policy vacuum is a product of the tension between the EU being the world's biggest democratic experiment and it being made up of national governments who hold the purse strings.
Without centralised executive powers – the gouvernement économique of President Sarkozy's dreams – the diversity of Europe also works against top-down change. Today's economic outlook ranges from Latvia's forecast 18 per cent ‘negative growth' for 2009 to Poland's actual growth. The financial cultures stretch from Britain's credit-bingeing property-flippers to Germany's discount-supermarket-addicted savers. What hope do Spaniards and Italians have of coping with a common pension policy when they cannot afford a universal unemployment benefit?
When the workforces of Western Europe begin to shrink from 2011, as they are forecast to do, will that fragile safety net break altogether? It is hard to know, because no one can predict a country's total liabilities – though the OECD thinks the average is 200-400 per cent of GDP. The maths is simpler than unravelling toxic assets – the living are a good audit trail – but we can't know how long people will live or when their private savings will run out. With each year of increased longevity adding 3-4 per cent to liabilities, even a small adjustment to calculations can make a great difference. Such uncertainty is compounded by state secrecy: nearly all European governments keep future liabilities off public pensions on their balance sheets.
The size of Europe's monumental public debt is only surpassed by the hidden liabilities
accumulated in Europe's short-sighted public pension schemes.
– Dr Martin De Vlieghere, University of Ghent
EVEN POLITICALLY DIFFICULT policies to lower debt and raise the pension age to sixty-eight are the equivalent of treading water when it comes to pensions. European pension liabilities outweigh declared public debt, and for many countries they outweigh GDP. Indeed, the gap between liabilities and dedicated assets is so great that today's thirty-year-old Italians would have to contribute 127 per cent of their salaries to the state pension scheme to guarantee receipt of the current pension.
Some nations are making progress, almost all of them smaller nations. This year Latvia, under threat of national bankruptcy, cut pensions by a tenth, while Hungary cut them by nearly that much. Denmark is moving to a system where the official retirement age moves up with life expectancy, and the Finnish Prime Minister, Matti Vanhanen, warned in June that he will be forced to deliver years of ‘painful cuts' to meet the costs of ageing.
Germany is alone among the largest European countries in undertaking significant change. German-owned companies, under government pressure, now contribute an average of £3.27 for every pound of new pension benefits credited to employees (after years of covering less than two-thirds of their pension liabilities with dedicated assets). For its part, the German government is seeking constitutional limits on budget deficits and has allowed schemes that ensure almost a third of labour costs are devoted to building up pensions.
The heart of the problem is that most European pensions are pay-as-you-go schemes. Like Germany's formerly wayward private schemes, most public and private schemes are not funded by accumulated assets, as in Australia's employer-funded superannuation system or Norway's oil-driven Sovereign Wealth Fund. Nor do retirement savings follow workers through a career. Instead, current workers fund previous generations of workers, and each generation passes its bill to the next.
This will suffice if the workforce and economy grow strongly, but when they shrink, a nation's low birth rates or loose fiscal policy can no longer be masked. Now that retirements last twice as long as they did forty years ago, some of these systems face collapse. For European workers, who rarely have private savings to fall back on and own homes at lower rates than do Australians, this scenario could be devastating.
An example of particularly bad pension management is the UK's Civil Service scheme, of which I am a member. This is one of the defined-benefit schemes to which seven out of ten British workers belong (compared with just one in ten in the more affordable defined-contribution schemes). While high entitlements combined with a forced retirement at sixty are personally agreeable, this is certainly not sustainable when the UK spends four pounds for every three it now collects in tax. Yet it continues to rack up pension liabilities equal to paying 19 per cent super contributions to each civil servant.
While it has been running up this bill, Britain has chosen to use its North Sea oil revenue on anything but pensions, in sharp contrast to Norway, its oil-field neighbour. The Norwegians now have a fund so strong that they saw the 2008 share wipe-out as an opportunity to cherry-pick underpriced assets from scared investors. Spain – without oil, and desperate to catch up to Europe's front-running nations – also took the easy road. There, more than two-thirds of people believe the state should be ‘primarily responsible' for pensions, yet these same people encouraged a property bubble as their back-up plan, rather than save for retirement. Spain's state depended on that property bubble for income, and now that the bubble has burst it faces rapidly increasing deficits and unemployment already spiralling beyond 18 per cent.
Everyone knows the money has run out...we will not see such riches again until my generation has
paid off every last unfunded public-sector pension liability, every last bit of debt kept Enron-style off the books, and all the other components of the structural hole in the public finances. That hole is
‘recovery-proof' – it will still be there even when the economy recovers.
– Camilla Cavendish, 40, columnist for The Times
ONLY IMMEDIATE RADICAL reform will address these issues. Some favour even the abolition of formal retirement. While that is politically impossible, lower or delayed access to entitlements, higher taxes, higher employment rates and more working-age immigrants are essential. Leaving reform too late will mean massive social tension or a suffocation of economic growth as governments desperately struggle to maintain entitlements.
How then might attitudes shift? Assumptions about retirement entitlements need to be remoulded. Europeans may offer in-principle support for private retirement savings, but they also equate state pensions and low retirement ages with social progress. They must accept that comfortable retirement now requires private savings and working until the age of seventy.
The most pragmatic approach is to ensure the pension bill is paid by all, not only the workforce. With some European states sucking up half of GDP in taxes already, it will be easier and less economically harmful to redistribute the tax burden rather than increase it sharply. The OECD concludes that property and indirect (consumption) taxes are the least harmful to long-term growth, which dovetails neatly with the need to maximise the number of people footing the bill. Europe will also have to figure out its attitude to migrants: can it shoulder the social pain in return for the economic gain? Anti-immigration parties fared well in the 2009 European elections, and countries from Spain to the Czech Republic are already paying immigrants to return home.
Whatever route Europeans take to rebalance their pension books, Norway's disciplined use of public funds and, on the other side of the world, Australia's mobilisation of private funds – through compulsory employer contributions – will feature in policy discussions. Norway's strong incentives to work until seventy make sense when you realise that their choice is born out of a culture of responsibility, a tangible belief in the benefits of ‘generational accounting'.
If Europeans take one lesson from this crisis, it is not that capitalism is broken, or that governments should attempt to solve every economic problem. It is that in dealing with money – whoever is doing the dealing – planning, saving and discipline can save a great deal of trouble. The economist Dambisa Moyo offers a proverb for dealing with failed policies: ‘The best time to plant a tree is twenty years ago. The second-best time is now.' For Europeans, their eventual return to economic growth is also their final chance at effective pension reform. The economic clash between Europe's ageing population and a young, rising Asia already resembles the Titanic hitting the iceberg. Europe would do well to make sure the lifeboats are in order. ♦