Business April 2012

Europe’s Real Crisis

The Continent’s problems are as much demographic as financial. They won’t go away soon.
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Annie Griffiths Belt/Corbis

All of us can breathe easy now: policy makers and analysts finally agree on how to fix Europe’s problems.

“Europe Debt Crisis Plan Hinges on Economic Growth,” declared the Los Angeles Times in October, after finance ministers announced what felt like the hundredth plan to seriously, no-foolin’-this-time, really rescue the European Union’s illiquid and insolvent states.

“Countries have to undergo significant structural reforms that would revamp growth,” said Mario Draghi, the head of the European Central Bank, in a December interview with the Financial Times.

“Austerity is not enough, even for budgetary discipline, if economic activity does not pick up a decent rate of growth,” Italian Prime Minister Mario Monti told The Economist in January.

Their words have been echoed in a thousand or more op-eds, policy briefs, and TV spots, for good reason. Growth could fix so many dire fiscal and political problems—not just in Europe, but all over the developed world.

If only economic growth could be delivered on demand, like a pizza, just minutes after we realize we want it. Unfortunately, growth (or at least the sustainable variety) is typically a long time in the baking, and dependent on two main ingredients: more workers and higher worker productivity. And much of Europe is short on the former. That has big implications for Europe’s future.

Consider Italy. It is no exaggeration to say that the fate of Italy is the fate of the euro zone: if Italy can keep its debt under control and its banking system solvent, the euro zone will probably make it; if Italy defaults, the resulting panic will probably force Portugal, Ireland, Greece, and Spain to follow suit.

This linchpin is under a great deal of strain. Italy’s public debt stands at $2.3 trillion, roughly 20 percent larger than the country’s GDP. If not for that debt, Italy would have run a slight budget surplus in 2011. But interest payments alone soaked up nearly 5 percent of the GDP, creating a deficit of about 3.6 percent of national income and increasing the debt even more.

This has left Italy incredibly vulnerable. For every percentage point that the interest rate on the debt increases, Italians have to divert another 1.2 percent of national income into debt payments. And because markets are worried about this problem, interest rates have been rising at a brisk clip, with only occasional pauses while the powers that be deploy yet another emergency rescue plan.

Sweating this debt down by austerity alone would take ages, cause immense suffering among people who depended on the cut services, and—as Greece has shown—draw fierce public opposition. Moreover, commentators like Paul Krugman argue that it would actually make the problem worse in the short term, because government austerity makes the economy contract. As they see it, trying to close Europe’s fiscal gaps with austerity alone is like trying to get out of a deep hole by digging harder.

Strong growth by Europe’s troubled debtor nations would of course offer a different, and less painful, way out. After all, if you make $30,000 a year, a $10,000 credit-card balance is crippling; but if you make $300,000 a year, it’s fairly trivial. The faster Italy’s economy expands, the more manageable Italy’s debt becomes.

But that’s where the dearth of workers comes into play. Everyone agrees that rapid growth would be much nicer than higher taxes and slashed pension payments. The hitch is that over the past five years, growth in the Italian economy hasn’t averaged even 1 percent a year. Soaring growth will be tough to achieve, because more and more Italians are getting too old to work—and fewer and fewer Italians have been having the babies needed to replace them.

Italy’s fertility rate has actually been inching up from its 1995 low of 1.19 children for every woman, but it is still only about 1.4—well below the number needed to replenish its population (2.1). As a result, even with some immigration, Italy’s population growth has been very slow. It will soon stall, and eventually go into reverse. And then, one by one, the rest of Europe’s nations will follow. Not one country on the Continent has a fertility rate high enough to replace its current population. Heavy debt and a shrinking population are a very bad combination.

Since the invention of birth control and antibiotics, country after country has gone through a fairly standard shift. First, the mortality rate drops, especially among the young and the aging, and that quickly translates into a bigger workforce. Then, birthrates drop, as families realize that they no longer need to birth a basketball team to ensure that a couple members will survive to adulthood. A falling birthrate means that parents can invest more in each child; with fewer mouths to feed, more and better food can nourish each of them, and children can spend more years in school, causing worker productivity to rise from one generation to the next. As the burden of bearing and rearing children lightens, mothers can do more work outside the home, boosting both household resources and the national economy.

In 1984, when Ronald Reagan spoke of “morning in America,” he was at least demographically accurate. The youngest members of America’s vast Baby Boom were in college; the oldest were on the brink of their peak earning power. America was about to reap what the economists David Bloom and David Canning have dubbed the “demographic dividend” of rising labor supply and productivity. Bloom and Canning’s analysis of East Asia and Ireland attributes a substantial fraction of the recent economic booms in those places to this dividend.

But the dividend does not last forever. Eventually, the baby bulge reaches retirement age, the labor force stops growing, and older workers start spending their savings, depleting the nation’s supply of capital. The virtuous cycle turns vicious. This is what is happening right now in much of southern Europe.

Is strong growth still possible once the demographic dividend has been paid out? Of course it is, at least in theory. Even if the workforce isn’t expanding, strong-enough gains in worker productivity can substantially lift the economy. Longer hours and longer careers can theoretically have the same effect. But it is far from clear that in practice, these solutions will work, given the advanced age of Europe’s workers.

To see why, picture two neighboring towns, sharing all the same infrastructure and economic opportunities, with one key difference: their median age. In the first town, which I’ll call Morningburg, the average resident is 28. In the second, which I’ll call Twilight City, the average householder is 58.

Research indicates that even with all the same resources at their disposal, these two places look very different, and not just because one’s grocery store does a booming business in diapers while the other’s has a whole aisle devoted to Centrum Silver.

In Morningburg, young workers are rapid, plastic learners, eager to try out new ways of doing things. Since they’re still hoping to make a name for themselves and maybe get rich, they take a lot of risks. They push their managers to expand into new markets, propose iffy but innovative product lines, maybe start their own firm if the boss won’t let them advance fast enough. For the right opportunity, they’ll put in 18-hour days for a year or more.

In Twilight City, time horizons are shorter—people aren’t looking for projects that will make them rich or famous 20 years from now. They are interested in conserving what they have. That’s mostly rational, given Twilighters’ life stage; but studies show that older people worry more than younger ones about losses and are therefore especially averse to risk. Twilighters also tire more easily and need more time off for illness, so hours worked slowly decline each year. Wages stay steady, however; Twilighters, like most people, get very angry if you try to cut their salary.

That makes Twilighters expensive—so when they lose a job, finding another is tough. As a result, Twilighters tend to cling fiercely to their positions, and may block younger workers from getting a foothold in the labor market.

The difficulty of reemployment contributes to Twilight City’s surprisingly high, but somewhat deceptive, rate of entrepreneurship. Looking closely, we find that businesses there are disproportionately owned by semi-retirees who have hung out a consulting shingle, or become part-time caterers, or invested in a hobby business like an antique store. These businesses typically don’t have much growth potential, in part because cautious Twilighters won’t (or can’t) borrow money for expansion.

Morningburg is a boomtown, prone to periodic savage busts when the young strivers realize that those fur-bearing-trout farms they invested in aren’t going to make them rich. Twilight City is a less volatile place—but little change also means little growth.

In theory, smart policy could make Twilight City look a little more like Morningburg: public investment and forced savings could boost research and business development; employment laws could be reformed to make labor markets more flexible; heavy investments could be made in education to improve the productivity of Twilight City’s few young workers.

In practice, all of this is likely to be fiercely opposed by Twilight City’s citizens, who tend to vote against change, particularly if it threatens their pensions or health care. Many of the most vehement public demonstrations in Europe over the past two decades have followed attempts at pension reform.

It is somewhat ironic that the first serious strains caused by Europe’s changing demographics are showing up in the Continent’s welfare budgets, because the pension systems themselves may well have shaped, and limited, Europe’s growth. The 20th century saw international adoption of social-security systems that promised defined benefits paid out of future tax revenue—known to pension experts as “paygo” systems, and to critics as Ponzi schemes. These systems have greatly eased fears of a destitute old age, but multiple studies show that as social-security systems become more generous (and old age more secure), people have fewer children. By one estimate, 50 to 60 percent of the difference between America’s (above-replacement) birthrate and Europe’s can be explained by the latter’s more generous systems. In other words, Europe’s pension system may have set in motion the very demographic decline that helped make that system—and some European governments—insolvent.

Pension and other welfare benefits, promised long ago when the workforce was expanding quickly, are at the heart of Europe’s current fiscal convulsions, which are perhaps a harbinger of worse to come. In David Canning’s view, the 2008 crash and its aftermath have merely moved up a long-inevitable implosion by 10 to 15 years. European nations “had unrealistic systems that were eventually going to cause a crisis,” he told me.

These difficulties are why almost everyone who studies the interaction of rich-world demographics and economic growth recommends raising the retirement age and forcing people to save more on their own, well before a debt crisis hits. “Aging is a good thing,” Canning says. “It means health improvements and longer lives. We only think it’s a bad thing because we’re trying to hang on to these institutions. We should be welcoming these changes, but changing our institutions to match.” He and Bloom, among others, are urging countries to use their demographic dividends wisely—to reinvest them in the things that make their workforces more productive. If they do that, perhaps living standards can keep rising.

“There’s a big difference between aggregate GDP growth and per capita GDP growth,” says Nick Eberstadt of the American Enterprise Institute. “For personal well-being, what matters is per capita GDP growth. You can certainly imagine a country with declining GDP but increasing per capita well-being.”

You certainly can imagine it, but it seems hard to actually achieve in a country with heavy national debt. If the population is shrinking but the debt burden isn’t, then promises to bondholders will weigh ever more heavily on each person. The government could default, of course, but the resulting crisis would also depress growth.

For the most part, Europe has already spent its demographic dividend. And the recent inability of countries like Spain and Greece to hit their deficit targets illustrates just how difficult coping with financial and fiscal instability can be when growth fails to materialize as expected. Neither voters nor employers were prepared to make the necessary compromises—and as the endless, fractious negotiations over Greek debt show, it is very hard to get them to adjust to reality, even when the alternative is disastrous. We shouldn’t necessarily expect people to become more resigned to compromise as time goes on—quite possibly we should expect the opposite.

Southern Europe is already living in Twilight City. And those of us who live in Morningburg or Afternoonville should pay close attention to what happens next, because eventually, we’re all heading to that neck of the woods. The United Nations estimates that by 2030, the number of people older than 60 will be growing more than three times as fast as the general population. By 2050, one in every five people will be over 60. In the developed world, the proportion will be more like one in three. Europe (along with Japan) is at the forefront of an unprecedented shift.

“The problem,” says Canning, “is that aging is a new thing. We know quite well what the effects of going to low fertility are—but we’ve never seen this sort of aging before, so it’s hard to make predictions.”

One prediction is safe, however: aging will present challenges that, as of now, no nation has adequately prepared to face.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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