Kieran Mc Morrow

The production function methodology for calculating potential growth rates and output gaps

This paper provides a detailed description of the current version of the Ecofin Council approved production function (PF) methodology which is used for assessing both the productive capacity (i.e. potential output) and cyclical position (i.e. output gaps) of EU economies. Compared with the previous 2010 paper on the same topic, there have been two significant changes to the PF methodology, namely an overhaul of the NAWRU methodology & the introduction of a new T+10 methodology.

Global Demographic Trends and Forecasts 1950–2050

This section examines past (1950–2000) and projected (2000–2050) population trends and assesses the implications of the latter for dependency ratio developments. As explained earlier, for the purposes of the historical and future analysis in this book ECFIN’s ageing model is split into five country blocks, the EU, the US, Japan and with the rest of the world broken into two distinct groups of countries, namely “fast ageing” and “slow ageing”. This classification for the rest of the world is similar to the approach adopted by Turner et al (1998) and is based on the dependency ratio calculations underpinning the UN’s global population projections. In effect those countries which are predicted to experience an increase in their overall dependency ratio over the coming decades are classified as fast ageing, with this latter group made up of OECD member countries (other than EU15, US, Japan, Mexico and Turkey) plus all of the Eastern European countries, Russia, China, Hong Kong, Korea, Singapore and Thailand. The slow ageing group simply includes all the remaining countries of the world not classified elsewhere13

Policy Response: How Can the EU and the World as a Whole Effectively Deal with the Challenges of Ageing?

The world economy is predicted to grow at an annual average rate of 21/2% over the period 2000–2050, which is 11/2 percentage points lower compared with the average for 1950–2000. All areas of the world will be negatively affected, with Japan expected to be particularly impacted with its average growth rate collapsing from 6% for the period 1950–2000 to less than 1% over the coming 50 years, with such a low rate of growth even comparing poorly relative to the average for the dismal 1990’s. In terms of changes in living standards, relative to the situation which existed in the 1990’s, the EU and Japan are predicted to experience annual average declines in the growth rate of GDP per capita of the order of 0.4%. This is double the deterioration predicted for the US and the fast ageing countries, with little change expected for the slow ageing group. Combined with this rather dismal real economy picture, the financial market effects are likely to be very significant, with sections 3 and 4 predicting that the next 50 years will witness large increases in age-related capital flows leading to current account imbalances, periodic bubble conditions, declines in real rates of return for investors and growing strains at the worldwide level in terms of income convergence which, on the basis of current trends, has the potential to undermine the present highly beneficial globalisation process.

An “Optimal” EU Pension Reform Strategy

The purpose of this final section is to bring together all the strands of the pension reform analysis which have been highlighted in the previous sections and to present the main elements of an “optimal” pension reform strategy for the EU. Optimal for this purpose is defined as a strategy which Firstly, boosts growth; Secondly, eases the budgetary strains of ageing and, Finally, does not provoke politically unsustainable changes in income distribution.

Global Ageing Scenario 2000–2050

The earlier sections have given a description of past and expected future population changes as well as a partial equilibrium analysis of the channels via which ageing is likely to impact, including a detailed assessment of the implications for external capital movements. The present section synthesises this information, using ECFIN’s general equilibrium ageing model, and presents its central view of the global economic and financial market impact of ageing populations over the next 50 years. In terms of the overall effect of ageing, figures for both potential output and income per capita (i.e. living standards — GDP growth rates adjusted for changes in trend population) need to be considered since there are significant differences between both these economic performance indicators for the different world regions covered by the ageing model.

Description of Model Used to Assess the Pension Reform Options

In section 1 the essential background details have been provided in terms of the pension reform debate and of the advantages and disadvantages of the different pension reform strategies. Given the difficulty of reaching operational conclusions regarding the choice of pension system to adopt and given the conflicting signals coming from any broad based literature review, it is clear that the final choice in terms of the actual pension reforms to be implemented rests to a large extent on the empirical supporting evidence. Using a new ageing model which has been constructed for this analysis, sections 3 to 5 will summarise the results of a number of simulations which systematically address the key questions underlying the pension reform debate. This present section has an introductory role in that it will present the main properties of the model to be used in the subsequent sections for evaluating the various parametric and systemic reform options.

PAYG System: Economic Assessment of the Main Parametric / Labour Market Reform Options: What is needed to Bring the System Back into Equilibrium?

In addition to the EPC announced labour market reforms described in sub-section 2.2 which impact on the underlying fundamentals of a country’s pension system, a large number of additional reforms are possible, with the following paragraphs confining themselves to an examination of firstly the implications of a parametric reform such as a reduction in the generosity of the PAYG pension system and secondly the effects of an increase in the effective retirement age up to the statutory age of 65. At the end of this section an attempt is also made to summarise the overall budgetary and growth effects of introducing a broad package of reforms, all of which will impact on the operation of the PAYG system. This final scenario combines the EPC’s labour market and generosity assumptions with an increase in the effective retirement age to 65 in order to see whether such a comprehensive overhaul of some of the key influences on the PAYG system would firstly be successful in stabilising the financial side of the public pension system, and secondly whether it would result in large gains in growth whilst simultaneously avoiding problems in terms of income distribution.

Overview of the Pension Reform Debate

For those coming to the pension reform debate for the first time the terminology used can often appear a little confused, with Table 1 below attempting to isolate the key issues and concepts which need to be kept in mind by the reader.

Economic Assessment of a Full / Partial Shift to Funding

Following on from section 4 where the key factors to be considered in any move to funding have been laid out, the present section goes on to provide a series of systemic simulations, where the internal rate of return and transition burden issues raised in the previous section are to the fore. While the simulation possibilities in this area are enormous the objective of the present section is to highlight a number of basic scenarios which illustrate key choices for a funded system, in particular the choice between a compulsory V voluntary system (sections 5.1 and 5.2) and whether a mixed PAYG / funded system provides a credible alternative to one or other system. In fact, as this section will make clear, a mixed pension system (75% PAYG / 25% funded) can be seen as a realistic scenario for the EU at the present time in that the size of the transition burden would appear to preclude an immediate shift out of the PAYG system, due to the large financial burden which would be placed on workers if such a shift was to be considered over only one generation. This is where the big contrast with the US starts to manifest itself since, according to Modigliani et al (2000), the US could make such a 100% transition to funding in a relatively painless way since “the US is in the lucky position of being able to provide all the additional resources needed to fund the system without ever raising payroll contributions”, although the authors do go on to stress that in order to achieve this, the transition period required would be long — many decades in fact.

Systemic Reform: 2 Key Factors to be Considered: Internal Rates of Return + Transition Burden

Before going on to present the specific systemic reform simulations in Section 5, it is important to discuss two crucial factors in determining the desirability and extent of any systemic reforms to be implemented, namely what will happen to the internal rates of return (IRR) of both the PAYG and funded systems over the next 50 years and secondly what is the likely size of the transition burden associated with a scrapping or significant shift away from the PAYG system in favour of a funded alternative. Any review of the pension reform literature will quickly show the importance of these two fundamental issues in terms of assessing the systemic reform options. In the case of the simulations in this section, the rate of return of the funded system is set equal to the real interest rate which in turn has been calibrated on the average real rate of return over the 1965–1995 period of a balanced portfolio of pension fund assets (i.e. 50% equities / 50% bonds) which has been calculated by Miles and Timmermann (1999) as being equal to 51/4% for this latter period, for a representative group of the EU’s Member States.