The retirement of the baby-boom generation, a lower fertility rate and increasing life expectancy will result in a relatively high number of elderly people whose income consists of benefits paid by the working generation and savings such as pensions and life insurance.
Many fear that current pension and healthcare systems will turn out to be unsustainable, and are urging for higher savings and investments to finance old age. Recent reforms that imply a greater reliance on funded pensions and policies aimed at reducing the public debt increase the supply of capital and puts downward pressure on interest rates.
Indeed, interest rates in Europe, the US and Japan are historically low, which creates room for higher investments and eventually results in greater productivity and higher growth rates. It is tempting to conclude that sufficiently increasing savings and investments is a panacea for all financial problems in an ageing society. But is it really so?
We must consider both the supply and demand sides. As people get older, the demand for labour-intensive services increases, whereas the need for new and more technologically advanced products decreases. This will lead to a smaller capital-intensive sector and a larger service sector. However, productivity develops very differently in these sectors.
Only the former benefits from extra investments. Productivity rises and people employed in this sector see their wages increase. Consequently, fewer people will want to work in the service sector, unless the wages keep pace with those in the more productive sector. But this will make services, which use more labour, much more expensive relative to commodities.
This process will even be intensified in an ageing society. The higher retirement savings may thus eventually turn out to be worth less than expected in purchasing power terms.
There will also be consequences for economic growth. An important aspect is the extent to which capital flows abroad. If higher savings are primarily invested domestically, this will lead to more capital expenditure. The capital-intensive sectors will expand and more people will be attracted to work there. This will also stimulate investments in research and development, education and training, and thus have a positive effect on economic growth. But the downside is that fewer people will be employed in the service sector, and services become more expensive.
But if the economy invests some of its capital abroad, higher savings that would have a depressing effect on the interest rate may then flow to other countries where the return is higher. Capital outflow will, however, affect the size of the different domestic sectors: capital is invested abroad, and future imports into the aged society can be financed from the returns.
Because commodities are typically more tradable internationally than services, these imports will primarily consist of commodities, and the domestic economy will concentrate more on the provision of services. But this will gradually imply a slowdown in economic growth because the productive sector where most innovations occur has shrunk. Higher savings for retirement may thus cause ‘Dutch
disease’, and long-term welfare may decrease. This will only happen if the domestic country is ageing more quickly than the rest of the world.
If all countries experience a similar pattern of ageing simultaneously and react in the same way, savings will rise everywhere and the return on capital will decrease worldwide, implying that investing abroad in order to escape the decreasing return is useless.
This shows that population ageing is a complicated issue that has different short- and long-term consequences that need careful examination.
Bas van Groezen is affiliated with the Utrecht School of Economics, Utrecht University, and Lex Meijdam is affiliated with Tilburg University and scientific director of the Network for Studies of Pensions, Aging and Retirement (Netspar).
This article is based on two of the authors’ publications co-authored with Harrie Verbon: ‘Increased pension savings: Blessing or curse? Social security reform in a two-sector growth model’, Economica, 2007, 74 (296): 736-755, and ‘Why pay-as-you-go pensions should exist in a service economy’, Scottish Journal of Political Economy, 2007, 54 (2): 151-165.