The Dismal Science
This epithet is no longer unique in applying to economics. It has clearly been joined by the industry reporting on the state of pensions. The coverage of the recent ONS study of the 2008 longevity projections is case in point. The headlines shrieked of 2 million centenarians among those aged over 50. In this article we examine the sub-plot to these headlines – that collectively we can’t afford such developments.
The first and most basic question is whether there is any evidence that the ageing of our society or our increased life-spans lower total productive output. Contrary to the many conjectures, there simply is no such evidence; in fact the opposite is the case. As pensions are simply a claim on future production we need to consider the relation between ageing, increasing expected longevity and productive output. It is immediately obvious that, from the industrial revolution onwards, increased production has been associated with ever older populations and greater longevity. But, perhaps, it may be argued that there is something unique to the post-war baby-boom generation situation. This hypothesis also lacks empirical support.
The evidence here is that greater healthy longevity is associated with higher productive output, though the direction of causality is unclear; society as a whole is not disadvantaged. Of course, the real cost of pensions is related to the time spent in retirement; with a normal retirement age of 65 for men and 60 for women, since 1981 this has increased from 6 to 13 years and 17 to 22 years respectively. In other words, more of total lifetime consumption now occurs in the period of retirement. The pension problem is then just a problem in distribution among the childhood, working and retired cohorts; this is a question for the political economy.
The usual analysis here considers dependency ratios; the proportion of retired to working cohorts. It is clear that there will be, perhaps, as few as two workers supporting each pensioner in the coming decades, which compares poorly with previous periods when four workers per pensioner were seen.
However, this analysis is flawed in an important dimension; it implicitly assumes that the working age group is of constant quality. Of course, increasing per capita productivity proves this assumption to be fallacious.
The investment dimension to productivity is important in this regard; there is a strong empirical relation between investment and GDP growth. Real per capita capital stock in the UK has more than doubled in the period since 1980; it is now around 220% of per capita GDP. This implies that saving or investment of around 11% of GDP is required simply to offset the depreciation and amortisation of this capital stock. Perhaps surprisingly, UK private sector saving has proved more than sufficient, even in 2009 when government dissaving reached 6% of GDP. The central point is that as the working age population declines as a proportion of the overall population, its capital intensity increases. If the dependency ratio halves, then capital intensity doubles, and over the period since 1980, the capital intensity of a worker has quadrupled.
There a related issue with the treatment of education. In national accounting, this is treated as a current expense, when clearly it is an investment in the human capital of the future generation; with UK public expenditure on education alone accounting for 5.4% of GDP, it is a material omission.
Some have advocated scheme funding as a mechanism for reducing the magnitude of the redistribution problem since dividends on these investments flow to the retired population. However, this raises the question of the division of productive output between capital and labour, a variant of the original problem. It is evident that international investment may serve as a disciplining mechanism in this national allocation game. It also highlights the need for pension schemes to invest in productive capital assets rather than to speculate in commodities and other non-productive instruments.
Innumerable analyses of the crisis have focussed upon residential housing and current consumption; statistics such as the Bank of England’s housing equity withdrawal series have been pored over in this regard. Since the second quarter of 2008 homeowners have injected £49.7 billion into housing equity, which, though impressive, still compares poorly with the withdrawal of £107.7 billion over the same period prior. The more interesting aspect of housing lies in a distributional effect. Residential housing is a non-productive investment. If one of the effects of the crisis is to encourage higher household saving and to concentrate investment in productive assets, rather than residential housing, then growth will be stimulated rather than depressed over the coming decades.
Real returns have declined markedly since the 1960s and many are now forecasting low or even lower returns to investment going forward. These returns are driven principally by the difference between investment and savings. However, over the past forty years savings rates have declined, principally as a result of lower household savings in the developed world; the decline in rates of return must therefore be attributed to lower investment demand. In fact globally, investment declined from 26.1% of GDP in 1974 to a low of 20.8% in 2002. Against a background of muted savings growth, from ageing in the developed world and increased consumption in the emerging economies, a return to the previous highs would result in real returns rising by perhaps 2% per annum.
The demand for investment globally, in infrastructure, productive assets and residential housing, is forecast to more than double by 2030. As this time the share of developed world investment would have declined to 47% of the global total from its current 65%. This raises questions over the conventional wisdom that economic growth is driven by small and medium sized enterprises, though this has been true in recent history. The widely expressed concern is that deleveraging in the banking sector will starve SMEs of credit and working capital and result in slower growth. However, global multinationals seem much better placed to exploit these trends in emerging market investment-based activity; such a development is unfortunately ambiguous in its effects upon UK employment.
The widely held belief that pensions are unsustainable and unaffordable seems to have some very questionable foundations. If DB schemes are now unaffordable, and the rate of closure of these schemes would suggest that the corporate sector widely believes this, then the source of the problem is not the economics of ageing, consumption or investment, but the deadweight costs of regulation, including the accounting.
Head of Research