Economic View: Welcome to the old country

When economics and politics clash, economics usually wins. The trouble is that the tussle can take a while and the longer it lasts, the greater the collateral damage it can generate.

Fortunately, the collapse of the European Union's Stability and Growth Pact last week was a relatively speedy affair. The pact has in effect been in abeyance since France refused to tighten fiscal policy when its deficit threatened to breach the 3 per cent limit. As it has been junked so swiftly, it has not had the time to do much harm.

The central problem has long been its bad design: it should have forced countries to correct their fiscal policy at the top of the economic cycle, not at the bottom. During the years of strong growth, governments should have been required to run larger surpluses or at least smaller deficits. You do not clamp down in a slump.

The markets recognise this and have taken the news calmly. In theory, a slightly looser fiscal policy has to be offset by a slightly tighter monetary policy. So the European Central Bank may bring forward its first rise in interest rates. It would be more ominous were long rates to start to rise steeply but as yet there is no real evidence of that. In any case, fiscal policy is gradually being tightened in both Germany and France, just not being tightened as swiftly as the EU rules would require.

So in the short term the economic impact is limited. There may be some political fallout but that is another matter. In any case, the eurozone recovery seems to be gathering pace. The new forecasts from the OECD have the eurozone growing at 1.8 per cent next year, with Germany at 1.4 per cent and France 1.7 per cent.

These countries have disappointed before; no one was predicting a year ago that Germany would not grow at all this year and France barely do so. But forward-looking indicators are consistent with a decent recovery next year and that must be the sensible outlook. Had the EU got its way and forced a tighter policy on Germany and France, then their recovery would have been more muted.

So on a one- or two-year view the European outlook is reasonably benign. Some revised version of the pact will be cobbled together and presented as a new, improved product. And a bit of growth will make everyone feel better. If the OECD is right and German consumption rises by more than 1 per cent next year, German living standards will be back above the level they were in 2001.

But Europe's fiscal problem is not what happens next year or the year after. It is what happens in 10 or more years' time. The chief economist of the OECD, Jean-Philippe Cotis, highlighted this in his introduction to the new forecasts, criticising governments for not using the good years to establish fiscal policies that would be sustainable in the long term.

He also introduced some more detailed work that the OECD has been doing on the fiscal consequences of the ageing of the developed world. The chart above, which looks at the change in the ratio of people of retirement age to those of working age, comes from this study. The black bars show the ratio at present and in 2050. On average now, the numbers of people of retirement age are about 23 per cent of those of working age, though the actual numbers of retired are higher because many people stop work before they are 65. When the present generation of young workers are retired in 2050, that proportion will have more than doubled.

While this is a problem for the entire developed world - the white bars are longer than the black in every case - there are wide variations. In Europe, Spain and Italy face the greatest pressure. Japan and much of eastern Europe will be in trouble. The position of the US, by contrast, is relatively benign, and within the EU, ourselves, the Dutch and the Danes look in the best shape.

This is a fiscal catastrophe. It simply will not be possible to pay anything like the present level of pensions unless other forms of spending, including on health and education, are slashed. The European welfare model has to change. So what is to be done?

There are five mathematical possibilities. One is to cut pensions. That is already politically difficult and will become more so as the number of pensioner voters rises.

A second is to raise contributions by people of working age. The trouble with this is that it tends to push people out of the workforce: employment rates are lower in countries with high social security and other direct taxation than those with lower rates. There is some evidence, too, that highly skilled people migrate to places where their real wages are higher.

A third possibility is to raise employment rates, so more people of working age stay in jobs. There is great scope for that in Europe but also social resistance. Besides, it may mean cutting tax rates, which runs counter to the previous remedy.

Four is to increase immigration. But that does not help as much as one might expect, partly because of skill gaps and partly because the scale of the immigration needed would create social tensions.

Five is to raise the retirement age, which is gradually happening but which also creates political difficulties. Actually, there is quite a lot of evidence that older people who stay in work are the happiest, but people do not like to think of being compelled to work longer than they had planned.

But this is Europe's real fiscal problem. So a cheer to the OECD for shouting about it. The long-term problem of fiscal deficits is what matters, not the death of the Stability and Growth Pact.