Download Representation and Economic Policy Ground Rules

Democratic Representation and Economic Policy Rules
in an Ageing Society
Lorenzo Bini Smaghi*
Member of Executive Board
of the
European Central Bank
Eumoniamaster – Institutional and Political Higher Education
Villa Morghen, Florence, 28 September 2006
* I thank L. Stracca for a contribution in the preparation of this speech and L. Fiorenza for editing assistance. The
responsibility for all views expressed belongs to the author alone.
The topic I would like to address today concerns the way in which population ageing affects the
ability of democratic institutions to represent the interests of their citizens over time. The issue is
very high on the agenda in the economic policy debate in many countries, including Italy.
In general terms, the problem derives from the fact that certain economic policy decisions taken on
a democratic basis – i.e., taking into account the specific interests prevailing at that time -- may
subsequently prove to be no longer representative of the general interest, because certain basic
parameters on which the initial decision was based have meanwhile changed. This problem is well
known in the economic literature analysing policy decisions taken under uncertainty and imperfect
information1. The solution to this time inconsistency problem is to adopt rules or institutions
capable of at least partially limiting the use of discretion in decision-making.
This type of solution is not substantially different from that of the protection of minorities in a
democracy. The objective is to prevent certain classes of citizens from being systematically
penalized by decisions taken by the majority (the so-called dictatorship of the majority). Indeed,
constitutional law aims at preventing easy change of the ground rules of the democratic game,
which might benefit in a systematic way only certain parties.
I would like to examine three policy instruments which can be used by democratically
representative institutions to offload the burden of paying for goods from which the current majority
gains an immediate benefit onto the shoulders of future generations: the inflation rate, the public
debt, and the pension system. The use of these policy instruments creates a problem of
representation of future generations, who may be penalised.
The three policy instruments have certain aspects in common.
First of all, these instruments often produce opposite effects in the short and medium-long term.
Therefore, they are generally used to benefit the current generation, whose interests are well
represented in current democratic institutions, while penalising the next generation, which is not yet
represented. Moreover, these instruments are not easily reversible. Once you start using tools such
as inflation, the public debt, or pension systems in a distortionary manner, it is not easy to backtrack
and to adopt measures going in the opposite direction which can nullify the initial effect or at least
partially compensate those who have been damaged by them. In fact, those who benefit from such
1
In economic literature, Brainard's principle argues that economic policy must be less pro-active in the presence of
uncertainty regarding the final result of a given decision. See W. Brainard (1969), Uncertainty and the Effectiveness of
Policy, American Economic Review 57, 411-425.
measures tend to consider them as “natural rights”, even though they are, in fact, taken without
proper consideration of the interests of those who are not yet represented in democratic institutions
and who will have to pay the bill. Finally, these instruments are typically used in a non-transparent
way. The medium-term effects that ought to discourage their use are not always clearly spelled out
when the decisions are made. The absence of an independent assessment or of stringent monitoring
by the media contributes to their lack of transparency.
These problems do not concern economic policy alone; they relate to many other aspects of
democratic life, such as the environment, urban planning and so forth.2
Population ageing exacerbates the problem because it increases the cost offloaded onto future
generations. The concept of “no taxation without representation” which is at the origin of liberal
democracies risks being violated.
The argument that I would like to put forward is that population ageing -- a problem shared by most
European countries -- demands that greater attention be focused on the need to ensure that intergenerational interests are properly represented. Such an objective can be implemented by
strengthening certain constraints on the use of discretion in the democratic institutions' decisionmaking processes.
The inflation rate
Monetary policy influences economic decisions via the interest rate. An expansionary monetary
policy, by reducing the real interest rate, prompts agents to bring forward their consumption and
investment spending, funding such spending through debt. Over time, however, such a policy tends
to push inflation up, penalising savers and those who have not been able to correctly foresee the rise
in prices -- typically, the less well-off.
Unpredictable shifts in inflation can lead to a major redistribution of income across generations and,
within each generation, between creditors and debtors. This redistribution is both opaque and
undemocratic, because it takes place quite some time after the policy decision is made, often
without those who suffer from its consequences being informed about it or being given a chance to
voice their opinion.
2
For instance, see H. P. Visser ‘T Hooft (1999): Justice to Future Generations and the Environment, Berlin: Springer.
Some calculations show that the high inflation rate recorded in Italy in the 1970s caused a
redistribution of income in favour of the public sector and firms, and to the detriment of households,
slashing the latter’s spending power by some 3.8% of total consumption.3
The experiences of the 1970s and 1980s and economic analysis have prompted governments to
separate monetary policy from the other economic policies which are more closely linked to the
political-electoral cycle.4 Nowadays, monetary policy in every industrially advanced country is
decided by independent central banks whose primary objective is to ensure price stability. This
makes it possible to prevent the inflation rate from being used to redistribute resources across
generations and social classes.
Central banks, while operating independently, are accountable for safeguarding the general interest.
The general interests are represented not through a democratically elected institution, but by a
specific mandate given to an independent authority accountable to the general public.
The public debt
Budget policy is an area which, typically, falls within the competence of the political authority that
directly represents the people's will, in other words, the Parliament and the Government. Budget
policy can nevertheless have a very important redistributive impact across generations. In
particular, the public debt shifts onto the shoulders of future generations (which do not yet enjoy
institutional representation) the burden of funding public spending in excess of revenue.5
The negative impact on future generations may be partially compensated for by the benefits that
these generations may gain from past higher public spending (for instance, if a large part of such
expenditure went into profitable investments), and if the population increases in such a way that the
burden of repaying the debt can be shared out over an increasing number of people. Yet this
compensation effect is reduced if, as happens in most industrially advanced countries, the level of
public spending over GDP is already very high and if the population is ageing. The rise in public
3
See Table 2 on page 308 in A. Cukierman, K. Lennan and F. Papadia (1985): Inflation-induced redistributions via
monetary assets in five European countries: 1974-1982. Commission of the European Communities, DirectorateGeneral for Economic and Financial Affairs.
4
For instance, see A. Alesina and L. H. Summers (1993): Central bank independence and macroeconomic
performance: some comparative evidence, Journal of Money, Credit and Banking, 25, 2. The authors show that the
central bank's independence of the political authorities promotes price stability without jeopardizing growth.
5
See A. Alesina and R. Perotti (1995): The political economy of budget deficits, IMF Staff Papers 42, pp. 1-31.
debt entails a heavy increase in the burden for future generations especially in countries where the
debt level itself is already very high.
The example of Italy in the 1980s is a case in point. In 1980 the public debt accounted for some
57% of GDP. In 1994, in just over 10 years, the public debt more than doubled, rising to 121.5% of
GDP. A European Commission calculation suggests that if the public debt is to be brought down to
the 60% level within the next 45 years, a structural budget surplus of 3% of GDP will be necessary
every single year till then. This means that the public finance policy pursued by democratically
elected Parliaments and Governments in the 1980s has offloaded onto the average Italian citizen an
additional burden (in the form of higher taxes or fewer public services) of up to €1,000 a year for
the next 45 years.6 We may well ask ourselves whether the services provided by the public
expenditure infrastructures, health, education, security and so justify this additional burden for the
next few decades.
A further problem is that it is difficult to give up benefits that have been decided on in the past but
that are not financially sustainable. For instance, the Italian budget deficit in 2006 is largely due to
an increase in primary public spending (before interest) of 3% of GDP compared with the year 2000
(rising from 41% of GDP to 44%), which has not been funded by a parallel increase in the tax
burden. If the aim is not to increase taxation -- indeed if many people wish to bring it down -- then
it is necessary to unwind the increase in spending of the past few years and to return to the
(sustainable) spending levels of the year 2000. This is however considered by many as a social
disaster, as if the level of public expenditure prevailing in 2000 was socially unacceptable.
In economic policy, as in medicine, prevention is better than cure. Given that it is difficult to give
up "acquired rights", even when the latter are not financially sustainable, it is preferable to enforce
budget constraints designed to prevent policies likely to increase the public debt.
The Maastricht Treaty imposes a binding constraint on the public debt, setting its ceiling at 3% of
GDP, and requiring a decrease in the debt at a satisfactory rate when that debt exceeds a given
threshold. This constraint is not just necessary in order to participate to monetary union, as the euro
area, it is also, and above all, a constraint of “good government” to prevent that the burden of
excessive debt policies is offloaded onto the future generations.
6
See Tables 1-3 below.
Pension system
Ageing population and negative demographics may jeopardize the financial and political
sustainability of pension systems. With people living longer and the birth rate dropping, there are
only three ways of ensuring that pension systems are funded: i) a cut in pension benefits; ii) an
increase in contributions; or iii) raising of the retirement age.7
To avoid having to adopt one of these three solutions, democratically representative institutions in
many countries have so far decided to offload the cost onto future generations via the public debt.
Such a method is sustainable as long as the population increases. As long as children outnumbered
their parents, they would shoulder the burden of funding their parents' long-term pensions. But with
the drop in the birth rate, that room for manoeuvre no longer exists. The only way for parents'
increasingly long-term pensions to be paid today is by increasing their children’s contributions, in
other words, by raising their children’s taxes.8
That is what the future seems to hold for many European countries. Due to the ageing population,
and in the absence of any pension system reform, tax revenue is going to have to rise by 2.9% of
GDP in Germany, by 4.3% in France, and by 1.3% in Italy between now and 2050 – assuming that
there is no further increase in the average life expectancy.9
An increase in contributions and taxes for the younger generations triggers a series of economic
distortions, in particular increases labour costs and reduces the incentive for longer term contracts.
The recent deterioration in the youth employment situation can be partly blamed on the excessive
contribution burden, due to the inability to tailor the burden to pension benefits for each generation.
Indeed, it is no coincidence that in countries where the pension system has been equitably reformed
in inter-generational terms youth employment is not an issue.
In most countries there are still no constitutional constraints which would link in a quasi automatic
way benefits and the retirement age to contributions and to the average life expectancy, so as to
prevent one generation from being paid its pension by the next generation, with benefits that the
latter generation could not itself hope to enjoy. For instance such mechanism could foresee that
working life is adjusted in a quasi automatic way to life expectancy. Yet in view of the financial and
7
See Table 4 below.
See European Commission's population forecasts shown in Table 5. For instance, the overall population of Italy is
expected to drop by 4 million between 2004 and 2050, while the working-age population is expected to drop by over 8
million.
9
See Table 5 below.
8
political turmoil we will be facing a few years from now, we may in fact have to resort in the future
to some kind of legal constraint à la Maastricht Treaty in order to resolve the pension problem.
Conclusions
The ageing of population and demographic trends in advanced countries are putting a new challenge
to the democratic representation of institutions responsible for economic policies. The solution is
not simple, but may require new constitutional rules that limit discretion in decision-making. To be
sure, never has it been more important for those that have the responsibility to represent public
interest to ensure that these interests are represented not only at a given moment in time but
consistently, across generations.
Table 1: Public debt, primary public spending, tax burden and primary surplus in Italy,
expressed as a percentage of GDP
Year
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Public debt
% GDP
37.4
42.0
48.2
50.3
50.2
55.7
54.7
54.8
59.9
59.3
56.9
58.9
63.6
68.4
74.4
80.5
84.5
88.6
90.5
93.1
94.7
98.0
105.2
115.6
121.5
121.2
120.6
118.1
114.9
113.7
109.2
108.7
105.5
104.2
103.8
106.4
107.4
107.7
Primary
expenditure
% GDP
30.5
32.5
34.0
32.6
31.5
35.7
34.0
34.1
36.1
35.7
36.7
39.8
40.2
41.0
41.3
42.5
42.3
42.3
42.3
42.1
43.2
42.5
41.5
43.9
42.5
40.8
40.8
40.8
40.9
41.4
40.8
41.7
41.7
43.1
43.0
43.5
43.5
43.6
Primary
surplus
% GDP
-1.6
-2.9
-4.8
-4.1
-3.5
-6.7
-3.9
-2.6
-3.3
-3.2
-3.1
-5.2
-4.1
-3.1
-3.5
-4.4
-3.1
-3.0
-2.7
-1.0
-1.6
0.1
1.9
2.5
1.8
3.8
4.3
6.5
5.1
4.9
4.4
3.2
2.7
1.7
1.3
0.4
0.5
0.2
Source: European Commission, AMECO database.
Net
Debt
% GDP
-3.2
-4.7
-6.9
-6.4
-6.2
-10.2
-7.8
-6.9
-8.4
-8.2
-8.4
-11.2
-11.1
-10.4
-11.4
-12.3
-11.4
-10.7
-10.4
-9.6
-10.7
-9.7
-9.2
-9.1
-8.8
-7.4
-6.9
-2.6
-2.8
-1.7
-1.9
-3.1
-2.9
-3.4
-3.4
-4.1
-4.1
-4.5
Tax
burden
% GDP
.
.
.
.
.
.
.
.
.
.
31.9
31.8
34.7
36.9
35.6
35.2
35.8
36.2
37.3
37.9
39.0
40.1
42.6
43.6
41.5
41.8
42.3
44.2
42.9
42.9
42.2
41.8
41.2
41.7
41.0
40.8
40.9
40.8
Table 2: Public spending on pensions, health, education, and unemployment benefits (20042050)
2000
Total spending linked to ageing
Spending on pensions
Spending on health: dynamic
scenario
Spending on education
Spending on unemployment
benefits
Hiring
Growth rate in labour force
productivity
Real GDP growth rate
Elderly people dependence index
2004
2005
2010
2020
2030
2040
2050
24.5
13.8
25.9
14.3
26.3
14.4
25.7
14.2
25.6
14.1
26.8
15.1
28.0
15.9
27.2
14.7
5.8
4.6
6.5
4.7
6.7
4.8
6.8
4.4
7.0
4.2
7.4
4.0
7.8
4.0
8.1
4.1
0.3
0.4
0.4
0.4
0.3
0.3
0.3
0.3
0.4
1.2
31.2
-0.5
0.0
31.9
1.2
1.9
33.9
1.7
1.6
39.4
1.7
0.9
48.0
1.7
0.8
62.1
1.7
1.2
67.4
Source: European Commission (2006): The impact of ageing on public expenditure: projections for the
EU25 Member States on pensions, health care, long-term care, education and unemployment transfers
(2004-2050), report prepared by the Economic Policy Committee and DG ECFIN.
Table 3: Public debt sensitivity to 2009 primary surplus (expressed as a percentage of GDP)
2010
2015
Primary surplus in 2009
3.6
3.0
2.5
2.0
1.5
2020
2030
2040
2050
Public Debt
99.0
99.6
100.1
100.6
101.1
84.2
87.7
90.8
93.9
97.0
69.5
76.2
82.0
87.9
93.7
46.4
60.5
72.8
85.1
97.4
36.7
60.4
81.2
102.0
122.7
25.7
60.2
90.6
120.9
151.2
Source: European Commission (2006): The impact of ageing on public expenditure: projections for the
EU25 Member States on pensions, health care, long-term care, education and unemployment transfers
(2004-2050), report prepared by the Economic Policy Committee and DG ECFIN.
Table 4: Population forecasts for some European countries
Germany
France
Italy
EU-15
Euro area
Total Population
2004
2050
82.5
77.7
59.9
65.1
57.9
53.8
382.7
388.3
308.6
308.4
Working age population
2004
2050
55.5
45.0
39.0
37.4
38.5
29.3
255.1
221.3
206.5
174.2
Elderly population (>65)
2004
2050
14.9
23.3
9.8
17.4
11.1
18.2
65.2
114.2
53.3
93.4
Source: European Commission (2006): The impact of ageing on public expenditure: projections for the
EU25 Member States on pensions, health care, long-term care, education and unemployment transfers
(2004-2050), report prepared by the Economic Policy Committee and DG ECFIN. Figures in millions of
inhabitants.
Table 5: Official and real retirement ages
Official and real retirement age in various countries
Men
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
Sweden
United Kingdom
United States
Average for EU-15
Source: OECD.
Women
real
official
real
official
59.6
65
58.9
60
58.5
65
56.8
62
65.3
67
62.1
67
60.8
65
59.8
65
59.3
60
59.4
60
60.9
65
60.2
65
62.4
58
60.9
58
65.2
66
66.2
66
61.2
65
60.5
60
59.8
65
59.8
65
61.0
65
59.1
65
65.8
65
63.5
65
61.6
65
61.3
65
63.5
65
62.0
65
63.1
65
61.2
60
65.0
65
62.9
65
61.9
64.4
60.8
63.2
Table 6
Old age and
seniority
pensions
Spending on
health
Long-term
assistance
Education
Unemployment
benefits
Total spending
linked to ageing
population
France
1.9
2.4
:
:
:
4.3*
Germany
2.5
1.1
:
-0.4
-0.2
2.9*
Italy
0.5
0.9
0.4
-0.4
-0.1
1.3
United
Kingdom
1.8
1.5
0.6
-0.1
:
3.7*
Spain
6.9
:
:
:
:
6.9*
Source: European Commission: Stability and Convergence programmes (SCP) updated to 2005/06.
* Incomplete figures: certain items of expenditure were not available when the SCPs were completed.