Postcards from Old Europe – Next Stop Oblivion?

Thank you very much for your positive reaction to last week’s post. I was especially pleased by your extensive use of the commenting system. You can rest assured that you have given me much input to fill my future postcards. I was originally planning on writing about Europe/US trade but my thoughts were hijacked by the comment thread about the impending extinction which supposedly awaits most of Old Europe.

Many of you have written comments on this subject but I hope that you’ll bear with me as I give you my 0.02 USD. A declining population is an economic negative because less people implies a declining supply of (potential) workers. The supply of warm bodies (labor) is one of the determinants of potential output growth – the others are the supply of capital and technological innovation (i.e. the growth of productivity). A country which is faced with a declining population therefore runs a real risk of entering economic stagnation and – ultimately – decline.

The German central bank, the Bundesbank, estimates potential output growth to be around 1.5%. This very low rate does not provide a large cushion to rest on. To put things in context: US output growth is estimated to be around 2.75 – 3.25% depending on who you ask. It stands to reason that any reduction in the labor force could quickly lead to a negative growth trend in Germany and other European countries who share the same demographic challenges.

Should we expect the land of beer and bratwurst to spiral into destitution in the next couple of years? Well, no. Let’s take a look at the relevant data: a German woman can expect to bear 1.4 children – this is below the replacement rate (2.1). Population Growth is provided by immigration which provides us with around 200,000 new residents per year. We now add in some increases in average life expectancy and arrive at 75 million Germans in 2050 (from 82 million today). This decrease in the labor pool would force potential output growth down to around 1%.

What can be done to prevent trend output growth from falling? The obvious answer is: “Have more children!”. The only problem is that you can’t legislate fertility and even if you could, you face a time-lag until the children enter the labor force. The alternative could be to let more immigrants into the country. This policy depends on being able to attract immigrants that are as well educated as the people they are replacing – otherwise you get a drop in labor productivity which is not helpful at all. Just letting people in is not the answer. The onus here is clearly on our politicians to implement an immigration policy which takes qualification into account and not just ethnic affiliation.

Other ways to increase trend output would force changes on today’s workers. You could try to persuade people to work longer hours or try to prevent people from taking early retirement. The “official” retirement age in this country is 65 – the only problem is that nobody actually works that long. The average retirement age is around 60. Only around 40% of people aged 55 – 64 still work (60% in the US, 70% in Sweden); the result of a perverse incentive system which led companies to shift older workers from their payroll to the government’s. A longer work week could increase the supply of available labor which could compensate for the decline in the labor force but is a political hot button just as later retirement is [Update: sentence changed – see comments].

I won’t go into the possibility of substituting capital for labor (won’t work efficiently) to enhance trend growth prospects here and I will not assume that technological innovation will grow by incredible leaps and bounds and thus enhance total factor productivity. A declining labor force is a problem which can only be solved by more people – not by building fully automated factories or by having robots greet each other at your local Carrefour. Changes in work habits (longer hours, …) can help in the short term, but won’t turn a declining and aging labor force into a young and sprightly reservoir of talent.

To sum it up: Germany – or Europe for that matter – is not going to fall off the face of the earth any time soon. Please keep in mind that every free society collectively decides its own course of action. If Europeans decide that they want to sacrifice 1.75% of trend growth for 30 days of paid vacation, free schools and universities, comprehensive health care, high job security and whatever else, then we should respect their choices. If we look at a study by the Centre for the Study of Living Standards, we see many countries in Old Europe compare favorably with the US in terms of quality of life. But if we are honest we know that we are comparing apples with oranges – Europe and the US appeal to different people in different ways. We should be happy that we have the possibility to sample the delights of both worlds and then wearily exclaim “a great place to visit, but I wouldn’t want to live there”.

Thanks for reading, I’m looking forward to seeing you next week. If you want to read more of my stuff, just go here!