Transcript Developing an MDGs Fiscal Framework: Lessons

Can Europe Afford to Grow Old?
Peter S. Heller
International Monetary Fund
March 31, 2006
The answer of course is yes, it
has no choice!

The more relevant questions are:


Can Europe afford its current expectations
as to the standard of living of the elderly
as the population ages and of the role of
the public sector in supporting that
standard of living? NO!
If not, then what policies can improve the
way Europe ages in terms of achieving
satisfactory economic and social outcomes
Key Challenges in Achieving a
Satisfactory Outcome






How can governments achieve a fiscally sustainable
position consistent with a satisfactory intergenerational income distribution and supportive of growth?
How to facilitate behavioral change and adjustment
in expectations of households?
How to move to higher GDP level and growth
trajectory?
How to address sources of inefficiency and market
failure that increase the cost of medical care?
When must governments act to exploit windows of
opportunity?
Are there additional Europe-specific challenges?
Achieving a Fiscally
Sustainable Position

The Aging Working Group Projections are a
useful starting point for discussion: Will not
here seek to dissect the assumptions



Illustrate substantial sustainability challenges
faced particularly by many of the smaller
European economies
IMF perspective: they are probably optimistic in a
number of ways, so that the fiscal sustainability
challenge is probably greater than portrayed
They leave unstated the policy changes that would
be required to achieve assumed labor force
participation and employment rates
Achieving a Fiscally
Sustainable Position

Level of unfunded implicit debt is far too
large: fiscal adjustment is inevitable

Will inevitably require a blend of




Fiscal adjustment—raising taxes or limiting expenditure
(including downsizing of infrastructure)
Benefit rationalization
Structural reforms
Avoid “dead end” solutions, viz., reliance only on



full primary gap adjustment: political economy challenge
annual fiscal deficit adjustment: much more costly
deferred structural reforms to pension system: political
economy challenge
Achieving a Fiscally
Sustainable Position


Level of unfunded implicit debt is far too large: fiscal
adjustment is inevitable
Its more than just demographics! Fiscal policy stance
must ensure resiliency and robustness in face of
numerous potential uncertainties:





Demographic uncertainties
Reaction functions of households in terms of savings
behavior
Interest rate movements in globalized, aging world
Climate change effects (sea level rise and storm surges; low
probability high consequence events re Gulf Stream shift;
sectoral shocks from change in temperature and
precipitation)
Other unknowable shocks (e.g., avian flu pandemic)
Achieving a Fiscally
Sustainable Position



Level of unfunded implicit debt is far too large: fiscal adjustment
is inevitable
Its more than just demographics! Fiscal policy must ensure
resiliency and robustness in face of numerous uncertainties
The cure should not be worse than the disease! Seek
policies that are supportive of growth; consider the
macroeconomic effects of alternative gap-closing
approaches


Raising payroll or income tax rates would be deleterious to
growth
Consider households savings/investment reactions to policy
choices
Achieving a Fiscally
Sustainable Position




Level of unfunded implicit debt is far too large: fiscal adjustment
is inevitable
Its more than just demographics! Fiscal policy must ensure
resiliency and robustness in face of numerous uncertainties
The cure should not be worse than the disease! Seek policies
that are supportive of growth; consider the macroeconomic
effects of alternative gap closing approaches
The solution should not compromise basic
intergenerational social insurance pact—preventing
poverty among the elderly


The policy solution must at least ensure a zero or first pillar
that provides a basic pension that is above poverty level;
A solution that excessively reduces the replacement rate
below an acceptable social norm will fail
Achieving a Fiscally
Sustainable Position





Level of unfunded implicit debt is far too large: fiscal adjustment
is inevitable
Its more than just demographics! Fiscal policy must ensure
resiliency and robustness in face of numerous uncertainties
The cure should not be worse than the disease! Seek policies
that are supportive of growth; consider the macroeconomic
effects of alternative gap closing approaches
The solution should not compromise basic intergenerational
social insurance pact—preventing poverty among the elderly
Achieving fiscal sustainability is only one part of the
challenge of making “aging affordable for Europe”



Leaves open the question of standard of living of elderly
Quality of public services being delivered
Competitiveness of economy
The challenge for governments:
Facilitate behavioral change and
adjustment in individual expectations







The work/retirement balance: the need for retirement age to rise
pari passu with improvements in life expectancy
Ensuring incentives exist for higher labor force participation by
older age groups/females
Encourage business toward greater flexibility in employment and
wage policy in adapting to elderly work force
Limiting individual expectations as to what medical care can be
publicly guaranteed and financed
Encourage greater risk pooling in private long-term care
insurance
Strengthened financial education and financial awareness
Foster provision of new financial products (longevity bonds,
alternative annuity instruments; investment-advice embedded
financial instruments; increased use of hedging strategies) and
raise quality of savings
Fostering a higher GDP level and growth
trajectory?





The fall in fertility rates, with limited migration, implies stabilized if not
falling population and a shrinking of the labor force: higher incomes
will thus derive from increased efficiency; greater labor force
participation, employment, and hours worked; and robust productivity
growth
An aging labor force can be a source of high productivity, but its not to
be taken for granted. Will require adaptation by business and
governments
Higher incomes will facilitate addressing needs of an aged population,
but will not solve distributional issues
Significant premium to be attached to rendering Europe attractive for
foreign investment and able to compete at the high end in globalized
product and service markets
Recognize that achieving greater competitiveness and flexibility may be
necessary simply to realize assumed productivity growth assumptions:

Possibility of unanticipated shocks: climate change; enhanced
competitiveness of China and India at high end; energy shocks
Lisbon Agenda plus


Efforts to enhance the functioning of labor markets will not be effective
in the absence of measures to open product and services markets to
greater competition
Enhance integration of national financial markets in order to facilitate
flow of capital across national boundaries in Europe—to effectively raise
quality of savings






(single payment system; securities settlement system; contract law
harmonization; development of market in asset-backed securities)
Greater regulatory harmonization
Achieve harmonization of tax laws and social insurance
Facilitate labor mobility
Provide opportunities for well-targeted immigration
Strengthened investments in human capital and R&D
portability
How to address sources of
inefficiency and market failure that
increase the cost of medical care?


In principle, higher spending on health, if well spent, efficiently produced, and
productive, should not be seen as a problem
But serious challenges relate to the operation of the medical care sector—
market failure, issues of financing, and inefficiencies:




Well-recognized sources of market failure: asymmetric information; moral hazard
associated with third party financing; monopoly power among providers; adverse
selection; also, in some countries, lack of competition for medical services
In some countries, absence of global budgetary rationing mechanism to limit access to
treatment in situations where the cost of treatment exceeds the likely benefits
(inadequate “value for money”
Pressures for rapid growth in medical care costs (income elasticity of demand
more than one; pressures associated with aging of population; pressures for
high technology adoption in medical care equipment and pharmaceuticals; lack
of testing for relative effectiveness of new high cost drugs; supplier incentives to
promote more care) require comprehensive global budget rationing, particularly
with public financing.
Without limits on extent of private insurance for co pays and deductibles, the
result can either be further pressure for sustained growth of medical care costs
or concerns on equitable access.
When must governments act to
exploit windows of opportunity?



The evidence is clear from sustainability analysis:
Acting early reduces the cost of adjustment:
Equally, the political economy of the measures
involved argues for early adjustment: an aging
electorate will prove more resistant to cutbacks in
benefits and more receptive to increased taxes on
working population
Delays may push public debt levels to a point where
financial markets begin to raise risk premium on
government borrowing—create vicious cycle in terms
of fiscal dynamic
Are their additional Europespecific challenges?

Dealing with substantial differences in the
size of imbalances across European countries



The potential fiscal imbalances are very large for
many European countries—more than Euro 10 or
25 average
What will be consequences of particular countries
falling further behind in their capacity to address
fiscal challenges of aging?
Potential for vicious circle—high tax rates, weak
benefits leading to out-migration that further
shrinks the size of the tax base
Euro-specific challenges



Dealing with substantial differences in the size of fiscal imbalances
across European countries
How to address pressures for cross-border mobility for medical care, in
response to differential availability of services? Issues of eligibility?
Cross-subsidization?
Opportunities of globalization








Outsourcing
Nontraded goods
Immigration
Potential risks: energy markets
Fiscal Space from inverted yield curve?
Reconciliation of global current account imbalances
Will new projections be used for SGP benchmarking, despite their
optimistic bias?
Role of asset sales—sale of patrimony?