13 th Economic Conference, Dubrovnik, 28 June 2007

1. “Macroeconomic implications of demographic developments in the euro area”Angela Maddaloni, Alberto Musso, Philipp Rother, Thomas Westermann, Melanie Ward-Warmedinger 13th Economic Conference, Dubrovnik, 28 June 2007 Disclaimer: Any views expressed are only the author’s own and do not necessarily reflect the views of the ECB or the Eurosystem

2. The current situation • From The Economist, 14 June 2007: “…Europe is fast becoming a barren, ageing, enfeebled place. Vast numbers of old people, [..] will be looked after, or neglected, by too few economically active adults, supplemented by restless crowds of migrants. The combination of low fertility, longer life and mass immigration will put intolerable pressure on public health, pensions and social services, leading (probably) to upheaval.” • Maybe this looks a bit gloomy, but…

3. The current situation • Available projections suggest that all Western countries face the prospect of population ageing • The problem is even more pronounced in the euro area, although there are considerable differences across countries concerning the pace of ageing • Important consequences for economic growth, labour markets, public finances and possibly financial markets

4. Overview Look at the impact of population ageing for: • Economic growth • Labour markets • Public finances • Financial markets

5. Impact on growth - demographic projections • Notwithstanding the high uncertainty surrounding population projections, working age population growth is projected to turn negative after 2010

6. Impact on growth - demographic projections • Compared to the US, euro areadependency ratio is growing much faster. After 2050 every third person will be older than 64

7. Impact on growth – demographic projections • The net migration rate is expected to fall up to 2010 and thereafter to stabilise in the euro area

8. Impact on growth - backward • In the euro area the contribution of demographic factors to growth decreased since 1980, reflecting increasing dependency ratio and a decline in labour productivity linked to ageing

9. Impact on growth - backward • Working age population growth contributed to real GDP growth in the US more than twice than in the euro area

10. Impact on growth – forward-scenario 1 • Assuming the labour productivity and labour utilisation evolve on average as in the past, there will be a negative impact on euro area growth

11. Impact on growth – forward-scenario 1 • Same scenario for the US…

12. Impact on growth – forward-scenario 2 • Assuming the labour productivity and labour utilisation grow in line with more optimistic assumptions, still there will be a negative impact on euro area growth

13. Impact on growth – forward-scenario 2 • Same scenario for the US…

14. Overview Go through the impact on: • Economic growth • Labour markets • Public finance • Financial markets What are the options for reforms?

15. Labour markets: current situation • Increase labour market participation, employment, productivity:there issignificant potential for female participation… Source: Eurostat

16. Labour markets: current situation • …and for an increased participation of 55-64 years old Source: Eurostat

17. Reform needs: labour markets • Reduce disincentives to enter work • interplay of taxes and benefits, early retirement schemes • Encourage female labour market entry • increase flexibility of working hours and provision of childcare services • Encourage workers to remain at work later in life • encourage policies of gradual exit from work, part-time work, increases in statutory retirement age • Invest in quality of education, research and development, increase lifelong learning and tackle old age discrimination

18. Reform needs: labour markets • The stabilisation of the old-age dependency ratios through migration alone is unlikely, due to the large number of migrants that would be required • The EC states that “using migration to fully compensate the impact of demographic ageing on the labor market is not a realistic option”.

19. Overview Go through the impact on: • Economic growth • Labour markets • Public finances • Financial markets What are the options for reforms?

20. Impact on public finances • The most important expenditure effects arise from public pension systems and health and long-term care • The estimated fiscal impact of the increase in pension expenditures (from different sources) find a cumulative increase in pension expenditure of more than 5 pp of GDP for most euro area countries, with pressure rising rapidly after 2010 (for some countries [GR, PT] up to 10 pp). • Looking at the outstanding stock of pension debt, it can be estimated an incremental implicit pension liability of close to 50% of GDP for the four largest euro area countries.

21. Impact on public finances • Offsetting effects through unemployment and education expenditure are small and uncertain • The EPC/European Commission projections may still turn out too low (e.g. favourable assumptions re. labour productivity) • Recent projections by the OECD point to a much more gloomy scenario, especially concerning the cost increases of public spending on health and long-term care.

22. Reform options: public finances Major reform needs in public pension systems and health care and long-term care arrangements: • Parametric reform of conventional pay-as-you-go pension systems necessary, but most likely insufficient • Systemic pension reform: shift part of pension financing to funded arrangements and reduce exposure to demographic risks • One option: notional defined contribution (PAYG) system combined with funded pillar • Health care: raise efficiency through setting the right incentives for all participating parties (insurers, providers, patients)

23. Overview Go through the impact on: • Economic growth • Labour markets • Public finance • Financial markets What are the options for reforms?

24. Impact on financial markets • Impact on prices and quantities due to changes in savings patterns and savings allocations of people belonging to different generations • Changes in financial structures linked to ongoing pension reforms • Workers are required to save more and contribute to funded pension arrangements

25. Impact on financial markets • Possible changes in savings patterns are based on the idea that wealth follows a life-cycle pattern; moreover risk tolerance may change with age

26. Theoretical and empirical analysis suggests that a meltdown is unlikely Forward-looking simulationsresults(usually based on closed-economy assumptions) models suggest that current workers will earn returns around 60 basis points below historical norm (given the assumptions in the models, this would represent an upper bound) Empirical studies report ambiguous results results are different across countries, which would imply that the relationship is affected by other fundamental factors Impact on financial markets

27. Impact on financial markets Will there be an asset meltdown? Probably not, but there could be an impact on prices: • people may change their saving and investment behaviour (and invest more in financial assets) especially if the benefits of public pension schemes are significantly reduced • international capital flows could help to smooth imbalances in domestic capital markets (for all kind of assets?)

28. Impact on financial markets: housing housing wealth as % of disposable income in the euro area… Source: ECB estimates based on national data

29. Impact on financial markets: housing • A significant portion of households’ income is invested in housing • the relationship between house prices and ageing remain largely an open question; difficult to disentangle the effect of age from other characteristics (income, marital status, education) • Recent developments in some countries (US, UK but also most of euro area countries) suggest that households may treat real estate as a source of portfolio diversification • may be risky: a future house prices meltdown?

30. Impact on financial markets: the retirement industry Euro area households have invested their private savings more via financial intermediaries (particularly retirement industry) Source: Eurosystem, as a % of total financial assets

31. Impact on financial markets: the retirement industry The retirement savings industry Role played by institutional investors is expected to grow and this may have a number of implications and possibly an impact on corporate governance Pension funds assets, as % of GDP, 2004 Source: OECD

32. Likely increase in savings for retirement over the next decades savings need to be invested and later on withdrawn to finance consumption of elderly Portfolio allocation of pension funds likely to exert significant pressures on financial markets possible shifts towards less risky assets as people become older? The extent of the impact is likely to depend on the financial structure and in particular on the social security arrangements if countries in continental Europe shift more strongly towards funded systems, financial asset prices could in theory show more pronounced swings related to demographic changes Impact on financial markets: the retirement industry

33. Shift from defined benefits to defined contributions plans portfolio choices will be more aligned with individuals’ preferences Revised industry regulations place more emphasis on risk management need to increase the supply of products to hedge against interest rate and inflation risk long-dated bonds inflation-linked products financial innovation Instruments to hedge against longevity risks are more problematic to develop annuity reverse mortgages Impact on financial markets: the retirement industry

34. Conclusions • Scenario analysis shows that projected demographic trends imply a decline in average GDP growth in the euro area to around 1% from 2020 to 2050 • It is important to implement the European Employment Guidelines to mitigate the impact of population ageing • Reforms of pension systems and health care arrangements are needed to counteract pressures on public expenditures • Impact on financial markets will derive from changes in portfolio sizes/allocations, the likely increase in the role of financial intermediaries and the related adjustment in the supply of some financial instruments