Waiting For Something To Turn Up: Europe’s Looming Pensions-based Sovereign Debt Crisis

As Irwin Stelzer argued in a recent opinion article in the Wall Street Journal, Spain’s Prime Minister José Luis Rodríguez Zapatero seems to be an admirer of Charles Dickens’s character Mr. Micawber. When asked what he plans to do about Spain’s 11.4% fiscal deficit, first he promises to extend the retirement age, only to later tell us the measure may not be necessary. Then he promises a public-sector wage freeze, only to have his Economy Minister, Elena Salgado, say he really doesn’t mean exactly what he seems to say. And in any event, we shouldn’t worry too much, since given that Spain is a serious country, somehow or other the fiscal deficit will be cut to 3% by 2013, even though most serious analysts consider the economic growth numbers on which the budget plans are based to have their origins more in the dreams of an Alice long lost in Wonderland than in any kind of sobre analysis of real possibilities. “We do have a plan,” deputy prime minister, Maria Teresa Fernandez de la Vega assures us, but to many that plan now seems to be little better than hoping, like the proverbial Mr. Micawber, that “something will turn up.”

The lastest to draw attention, to the problematic nature of this “wait and see” approach – and to the gaping hole which is now yawning in Spain’s national balance sheet – is the credit ratings agency Fitch, who only last week warned that many Western governments now face unsustainable debt dynamics following measures taken to address the financial crisis.

The agency singled out Britain, France and Spain as being in special and urgent need of outlining plans to strengthen their public finances if they don’t want to risk losing their current highly prized AAA ranking.

This strong and direct warning was issued by Brian Coulton, Head of Global Economics at Fitch, who said “High-grade sovereign governments need to articulate more credible and stronger fiscal consolidation plans during the course of 2010 to underpin confidence in the sustainability of public finances over the medium-term and their commitment to low and stable inflation. The UK, Spain and France in particular must outline more credible fiscal consolidation programmes over the coming year given the pace of fiscal deterioration and the budgetary challenges they face in stabilising public debt.”

Yet, while criticising Portugal’s gradual approach to fiscal consolidation as a matter of “concern” Fitch senior director Paul Rawkins also argued that the Spanish govenment had acted swiftly in announcing plans to consolidate public finances. Nonetheless he did still warn that the economic risks facing Spain remain very high, especially since the pace of decline in tax revenues is dramatic enough to be preoccupying, while continuing “labour market inflexibilities could well prolong the economic adjustment”.

The current problem facing Spain (and other similarly affected countries) has its roots in two quite distinct sources. In the first place measures taken to counteract the impact of the financial crisis have been inadequate and have simply produced large short term deficits. However to this short term liquidity and adjustment problem must now be added the further dimension of longer term impacts on public finances which have their origins lie in ageing populations, and the effect on economic growth of having older and smaller working-age populations.

Regarding the first, as Willem Buiter, now chief economist at Citi has pointed out, more than 40 per cent of global GDP is currently being produced in countries (overwhelmingly advanced economies) running fiscal deficits of 10 per cent of GDP or more. Over most of the last 30 years, this level fluctuated in the 0-5 per cent range and was dominated by debt form emerging economies. So the crisis marks a watershed, from which there will likely be no turning back, and in many ways could not have come at a worse moment for those countries who still have to undertake substantial pension reform to put their nation finances on a solid footing when faced with the unprecedented ageing which lies ahead.

Indeed, to take the Greek case, while the short term fiscal deficit has been the focus of most of the press attention, the longer term problem associated with the funding of Greek pensions far outweighs issues associated with the falsifying of national accounts in the early years of this century. A recent report by the European Commission found that Greek spending on pensions and health care for its ageing population, if left unchecked, would soar from just over 20 percent of GDP today to around 37 percent of G.D.P. by 2060. And Greece is simply an early warning indicator of troubles to yet to come, in larger countries like Germany, France, Spain and Italy who have all relied for decades on pay as you go type state-financed pension schemes. Now, governments across Europe are being pressed to re-examine their commitments to providing generous pensions over extended retirements because fiscal issues associated with the downturn have suddenly pushed at least part of these previously hidden costs up to the surface.

In fact, unfunded pension liabilities far outweigh the high levels of official sovereign debt. According to research by Jagadeesh Gokhale, an economist at the Cato Institute in Washington, bringing Greece’s pension obligations onto its balance sheet would show that the government’s debt is in reality equal to something like 875 percent of its gross domestic product. That would be the highest debt level in the 16-nation euro zone, and far above Greece’s official debt level of 113 percent. Other countries have obscured their total obligations as well. In France, where the official debt level is 76 percent of economic output, total debt rises to 549 percent once all of its current pension promises are taken into account. Similarly, in Germany, the current debt level of 69 percent would soar to 418 percent. Of course, these numbers are arguable, and may well be in the excessively high range, but the fact still remains: outstanding and unfunded liabilities are huge, and would have been difficult to honour even without the present crisis. As it is, we are now in danger of spending the seedcorn which could have been harvested later on down the road.

Public opinion has yet to assimilate the seriousness of the issues involved here. As Pimco Chief Executive Mohamed El-Erian said in a recent FT Opinion article, the importance of the shock to public finances in advanced economies is not yet sufficiently appreciated and understood. With time, this issue will prove to be highly consequential. The latest Fitch report is simply another warning shot. The sooner we all recognise the, the greater the probability of our being able to stay ahead of the disruptions this adjustment to reality will cause. It is time to stop simply waiting around to see what is going to turn up, since if we do continue like this we won’t like what we eventually find.

This entry was posted in A Fistful Of Euros, Economics and demography, Economics: Country briefings by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

11 thoughts on “Waiting For Something To Turn Up: Europe’s Looming Pensions-based Sovereign Debt Crisis

  1. Et tu, Edward? Why aren’t these people SHOCKED by the US’s unfunded defence liability or the UK’s unfunded police liability or China’s unfunded railways liability? It really is just an exercise in “well, let’s arbitrarily decide to capitalise the public pensions bill out to an infinite horizon, even more arbitrarily assign it to this year, and even more arbitrarily ignore the entire asset side of the balance sheet”?

  2. Cato? Come on.

    The pay as you go system in germany has survived two world wars and two great inflations. You can’t say the same for capital based retirements systems. Especially during this crisis. And this projections about level of debt in 2060 if unchecked are always a bit silly. Who can really project the growth rate of healthcare costs this far out?

    But I am more astonished with your obsession about spanish public finances. The worry about the UK, France, Greece and so on I can understand. Looking at the year 2007 as last per crisis year the budgets of thia countries were in deficit during good economic times. If a country can not balance it’s budget during years of growth there is reason to worry.
    But in Spain the budget was balanced in 2007 and the debt per gdp only 40% or so. The current public deficits have been caused by the economic crisis. Isn’t that the problem and the public deficit only a symptom?

  3. “US’s unfunded defence liability”

    Another point. The US military budget is financed by considerable boowing right now. But everybody obsesses about the Social Security system, that is in surplus now and could perhaps run a deficit in ten years. (If you ignore the trust fund).

    And no, military spending does causes hidden liabilities: Military spending and war now after is causing spending for the VA for decades to come.

  4. Industry groups were telling the same stories when Bismark implement the first basic social security system a hundred years ago 🙂

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  6. Edward,

    While the situation of public finances is between dire and awful in most places, it is inexact to add pension costs woes to the already overlong list of problems, at least for France (I don’t feel knowledgeable enough on Spain and Greece to comment on their specific case).

    This bizarre concept of ‘unfunded pension liabilities’ has been floated around for some time from a far away, specific location of the political spectrum. As the objective of the Cato institute seems to be to make the editorial staff of The Economist look like Bolsheviks, perhaps we should use their output with some amount of caution. Furthermore, barking at the wrong retirement tree allows the collapsing of the surrounding forest to remain unnoticed.

    Consider a fictive country, that we shall name the Un. St. of Am., where the government plans to spend 3 % of GDP each year for Defence budget in the next 50 years. 3 % of GDP, 50 years – and voilà ! My Cato-tonic magic wand has just created a 150 % of unfounded liabilities. The Cato institute might not be amused and point out that Defence budget of the Un. St. of Am. for year 20xx shall be financed by tax revenue of said year 20xx. Well, it is exactly the same thing for French pensions.

    The répartition system of French pensions makes worker pay, from deduction on their salary, for the pensions of retired. The system has thus three outputs: the amount of working people, the amount of retired, and the amount transferred from the first to the second. Thus there are 3 dependent variables to adjust: the age of retirement (or, in France, its proxy, see below), the amount of tax paid by workers, and the level of the pensions.

    This system is extremely slow-moving. Low-frequency changes come from demography and can be predicted 20 years in advance, with economic up and downs adding some unpredictable amount of noise. Thus it is extremely easy to perform small trajectory corrections that over time have a huge effect.

    Accordingly, while health care system (Assurance Maladie) has been a recurrent financial nightmare for the last 30 years in France, the pension system has had none of these problems. In 2000 Insee predicted that some serious adjustments (read: painful changes in some of the 3 variables) would be needed by 2020-2030 to compensate for the aging of the population. With the French demography of the last ten years, Insee now says that it’s about fine until 2050. Thus over the last years there have been regular, incremental increases of the durée de cotisation to compensate for the regular, incremental aging of the population (the French government didn’t touch the symbolic 60 years retirement age, but moved up the number of years (or, more specifically, trimesters), that people need to work in order to claim a full pension. This kolossal finesse seems to have mystified workers and economic commentators alike). Thus, the total work period in people life will increase with life expectation, which is normal and logical. People might also prefer to work until 75 and die at 95 than to work until 60 and die at 80.

    The French retirement system is sound, will not collapse overnight, and will certainly not ask unexpectedly for a bailout. It is therefore better behaved than the American financial system that is close to the heart of the Cato Institute. What is true for France is also probably true for Germany, where the 3 variables will, however, have to be adjusted a bit more than in France to address the effects of the poor demography.

    Meanwhile, the parts of the blogosphère that correctly predicted the financial troubles of the last 3 years seem to indicate that we are due for an encore. Look at the situation of the alternative retirement system, capitalisation – ie retirement funds. Bloated until 2007 by stock market speculation, these funds have started to collapse. In the US, more and more cities, counties and states realize they soon won’t have the money to pay the (public sector) pensioners anymore. Some think of bankrupcy to break their contractual obligations. The courts will have to decide. If the stock market falls, again, by 50 %, what will happen to these public sector retirement funds? What will happen, more generally, to the private retirement funds?

    A lot of retirement funds, from public and private sectors alike, have been lured into underfunding and overpromising by the stratospheric returns of the Ponzi financial years. Maybe the Cato Institute could ruminate some conclusions on the effect of the ongoing financial crisis on such schemes. Whether they do or not, we will find out. Fast.

  7. Not only is there a debt timebomb, but there is also a tax bombshell coming too: I hear Europeans have promised to pay well over 1000% of GDP in taxes during the next century!

    I think Perplexed is right, and Edward here is wrong. They’ve got this myth in the US too:


    All these debt numbers like “875 percent of its gross domestic product” are what will theoretically have to be paid over several decades, not one year (I mean this should be obvious, just do a quick sanity check on these numbers: why would any country have to pay hundreds of percent of GDP on pensions, unless it was over decades? How much do you think pensions are?).

    This was a very basic error Edward.

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