Alistair Dieppe et al. Public Debt, Population Ageing and Medium-Term Growth

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Occasional Papers 2/2015

Alistair Dieppe, Paolo Guarda, Maria Albani, Alberto González Pandiella, Esther Gordo, Owen Grech, Delphine Irac, Juha Kilponen, Dmitry Kulikov, Luca Marchiori, Ricardo Mourinho Félix, Niki Papadopoulou, Lisa Rodano, Dimitris Sideris, Edgar Vogel*. Public Debt, Population Ageing and Medium-Term Growth

This paper examines the impact of public debt and population ageing on medium-term growth. In many EU countries, public debt rose significantly following the financial crisis and the persistent weakness of economic growth will probably stretch fiscal consolidation efforts into the medium term. This will overlap with the economic and financial challenges raised by rapidly ageing populations, which will lower potential growth and increase pressure to reform public pension systems based on the pay-as-you-go principle. Applying a variety of macro-economic models, this paper produces the following main findings (i) a sustained fiscal consolidation could boost annual real growth by 0.5% on average over the period to 2020, (ii) raising labour force participation rates to meet EU2020 targets could increase annual growth by 0.1% on average over the period to 2030, (iii) reforms to pension benefits can mitigate the tax increase required to finance pay-as-you-go systems in ageing economies, raising annual growth in GDP per capita by 0.2%−0 .5% on average over the period to 2040.

Section 2 evaluates the impact of fiscal consolidation on medium-term growth in EU countries. The ECB’s new Multi-Country Model (NMCM) is used to construct plausible medium-term scenarios extending to 2020. Separate simulations for the main country blocks of the NMCM analyse the impact of a harmonised fiscal consolidation effort. Results indicate heterogeneous effects of fiscal consolidation across the main euro area countries, reflecting different estimates of consumption and investment sensitivity as well as speed of adjustment in labour and product markets, but also different initial debt levels and differences in size/openness (and therefore competitiveness effects). The sovereign risk channel suggests that reductions in risk premia may help to attenuate the contractionary effect of fiscal consolidation. If policy is credible and sovereign bond yields fall in response to declines in the public debt-to-GDP ratio, this channel can be strengthened by forwardlooking financial markets, as these will anticipate announced reductions in debt. The effect remains significant even if there is only imperfect passthrough from sovereign yields to the financing conditions faced by households and firms.

Section 3 adopts a longer-term perspective, focussing on the impact of population ageing. The standard growth accounting framework is extended to disaggregate the labour input into different categories (by age, sex, citizenship and education). This disaggregated approach emphasises that population ageing will generate a composition effect on the average labour participation rate, lowering the contribution of labour to potential growth. An illustration with Italian data indicates that migration assumptions can be crucial to determine medium-term potential growth. The proposed approach can also assess the impact on potential growth of structural reforms aimed at raising participation rates in specific segments of the population (e.g. women or older workers).

Section 4 extends the analysis of ageing from the partial equilibrium perspective of growth accounting to a general equilibrium framework. Three National Central Banks (NCBs) of the euro area have adapted OLG macromodels to study demographic change. Although calibrated to different countries (Portugal, Luxembourg and Finland), these models are simulated using a harmonised demographic shock designed to compare the impact on mediumterm growth of different policy responses. Responding solely through higher social contributions/labour taxes will require unrealistic adjustments and lower medium-term growth. A 2-year increase in the retirement age reduces pension costs and increases social contributions, but the increase in taxation required to stabilise public debt remains unrealistic and continues to lower medium-term growth substantially. When these measures are combined with a reduction in pension replacement rates, labour supply rises and the impact on growth is mitigated. It is also possible to raise consumption taxes to limit the required increase in social contributions/labour taxes, further boosting medium-term growth. 

To summarize the conclusions of this paper, despite considerable heterogeneity across EU countries, medium term growth prospects are weak given the challenges posed by high public debt and ageing populations. The NMCM simulations suggest that credible fiscal consolidation can improve growth prospects, especially since countries with high initial debt levels can potentially benefit from sharp reductions in the sovereign risk premium. The growth accounting analysis quantifies the effect of ageing populations on medium-term growth, with a focus on how structural reforms to raise labour participation rates can boost labour input. The DSGE simulations suggest that current public pension systems based on the pay-as-you-go principle will become unsustainable as the population ages, requiring appropriate reforms to address this challenge. Structural reforms to improve the functioning of labour and product markets can contribute to improving medium-term growth prospects.

The paper carries three main implications for economic modelling. First, the international perspective is important (there can be international spillovers through labour and capital markets as well as through trade). Second, agent heterogeneity should not be neglected (composition effects on labour participation can affect aggregate outcomes). Third, models need to analyse the interaction between different policies.

The paper also contains several policy implications. There is substantial evidence that higher public debt impairs long-term economic growth. Empirical estimates suggest a critical debt threshold around 90% of GDP, but it is important to keep debt well below this level to provide sufficient “fiscal space” to counter adverse shocks. Since several Member States have seen debt increase rapidly since the crisis, action is required to return to debt levels that do not hinder medium-term growth. In the medium-term, the sovereign risk channel may foster growth by lowering risk premia in response to current efforts at fiscal consolidation. However, this requires financial markets to perceive fiscal commitments as credible and pass through lower sovereign yields to the financing conditions faced by firms and households. Population ageing will also pose a substantial challenge to controlling debt and maintaining medium-term growth. The projected drop in revenue and explosion in expenditures from public pension systems will require substantial reform. At the European level, fiscal policy coordination and greater labour migration may help the transition. However, pension reforms must combine several different policy measures. Although increases in social contributions/labour taxes may be politically attractive, they cannot bear all the adjustment without creating perverse incentive effects, lowering labour supply and medium term growth. A combination of measures with offsetting effects is required since agents will adjust their behaviour in general equilibrium.


The occasional paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB or other National Central Banks.