Europe's Retirement Blues

by L. Jacobo Rodríguez

L. Jacobo Rodríguez is assistant director of the Project on Global Economic Liberty at the Cato Institute.

Social Security may have an uncertain future in the United States -- President Clinton’s announcement that he wants to use the budget surplus to save the program notwithstanding -- but Europe’s pension programs are on even shakier ground. Monetary union and high unemployment will grab most of the economic headlines in Western Europe during 1998, but no economic issue facing the European Union today is more important than the crisis in public pay-as-you-go pension systems. EU leaders are fearful of the political repercussions of dismantling welfare states that are collapsing under their own weight and have thus merely tinkered with those systems, enacting cosmetic reforms here and there while keeping their basic structure intact.

The reforms, however, will not prevent those systems from going bankrupt. In 1996 the Organization for Economic Cooperation and Development estimated that the net present value of future social security commitments as a percentage of gross domestic product amounted to at least two and a half times the size of GDP in 9 of 13 EU countries (figures were not available for Luxembourg and Greece), and the net present value of the unfunded pension liability exceeded 100 percent of GDP in 6 of those 13 EU countries.

In a pay-as-you-go system, the government taxes active workers to pay for the pension benefits of retired workers, thus severing the link between effort and reward. Contributions to social security are a tax on the use of labor, not an investment. As the elderly become a larger part of the EU’s population, the ratio of active workers to retired workers decreases, which means that European workers will have to pay even higher taxes than they are paying today to finance social security programs. With 18 million workers unemployed (about 11 percent of the EU’s labor force), the negative impact of high payroll taxes on employment is already evident. Consequently, any policies that further increase the cost of labor would be politically unpopular and economically unsound.

A reduction of benefits would be just as unpopular and insufficient to stave off the eventual bankruptcy of the system. Reducing benefits would also be unfair to senior citizens, most of whom, because they have been deprived of the satisfaction and dignity of providing for their own retirement, depend on the government for their retirement income. Finally, from a politician’s point of view, reducing pension benefits is tantamount to political suicide because senior citizens make up about 16 percent of the EU’s total population (and, of course, a higher percentage of the voting population).

The third possible solution for EU countries might be to inflate or borrow their way out of the crisis. But the Maastricht criteria for monetary union do not allow any member country to have an inflation rate 1.5 percentage points higher than the average of the three lowest inflation rates of member countries. And, although the implicit debt in pay-as-you-go pension systems is not included in the criteria for the public debt, the market punishes countries with profligate governments in today’s global economy.

Government-friendly measures will do little to alleviate the crisis in social security and much to spawn intergenerational conflict in the near future as fewer and fewer workers are asked to support more and more retirees. But that conflict would be avoided if continental Europeans were to implement a reform they have so far been reluctant even to consider: privatization.

The private system of individual pension savings accounts has worked very well in Latin America, especially in Chile, where it was first implemented in 1981. Critics of fully funded private pension systems acknowledge that those systems provide better returns, even as they contend that the transition would be too painful in industrialized countries to make such accounts a viable alternative. It is worth noting, however, that some Latin American countries have successfully made the transition under economic circumstances that are much worse than those facing any EU nation today.

The privatization of social security will strengthen civil society in the EU in the same way it has in those Latin American countries that have followed Chile’s example. Social security there has ceased to be a redistributionist program under which different groups compete against each other in the political arena to determine which group benefits at the expense of the others. Instead, privatization has established a direct link between individual efforts and rewards. In addition, a large percentage of the population, formerly disenfranchised, has obtained visible property rights and now has a stake in the economy through pension savings accounts.

The European Union has greatly expanded its trade relations with Latin America. Now it’s time for Europe to import a Latin American social policy idea, pension privatization, that offers the only opportunity for European workers to enjoy a decent retirement. In fact, the United States would also do well to learn from our Latin American neighbors.

This article originally appeared in The Journal of Commerce on February 3, 1998.