Calculating the cost: the consequences of excessive optimism in projections of economic growth

David Kingman argues that current assessments for spending on the aged as a percentage of GDP are flawed, and unfair to future generations.

The cost of future liabilities is often expressed as a percentage of Gross Domestic Product (GDP), i.e. how much of the country’s economic output they are projected to be worth. However, this is not necessarily a helpful way of thinking about them.

For example, to mark the public sector pension strikes on 30 June, Cabinet Office Minister Francis Maude appeared on the BBC’s Today Programme to argue that the present arrangements are unaffordable. However, the presenter, Evan Davis, countered him by presenting figures from the Hutton Report which seemed to project the cost of public sector pensions falling as proportion of economic output, from 1.9% of GDP in the current financial year to 1.4% in 2060-61.

This statistic then received a large amount of coverage because it helped convey the idea – popular in some quarters – that the government was unfairly attacking public sector pensions when they didn’t need reforming, because they were going to become cheaper anyway.

However, the people proposing this argument had made a serious error: the facts from the Hutton Report had been misinterpreted. What it actually says is that, if the government implements all the reforms it has proposed to public sector pensions, including later retirement ages, higher employee contributions, and switching from the RPI to the CPI, then they should decrease in cost to 1.4% of GDP.

In other words, opponents of these reforms – either accidently or maliciously – were using the positive results created by projecting their impacts to argue that they didn’t need to be implemented.

This mistake became widely circulated: BBC Political Editor Nick Robinson was just one journalist who got caught out by writing an article that contained the misleading figures, and then had to add an amendment explaining why they were inaccurate once the Treasury had clarified the situation that evening.

Had the liabilities simply been expressed as cash amounts, the difference would have been more obvious.

An intergenerational gamble

The problem with suggesting pensions spending will require a certain percentage of GDP in 2060, for example, is that big assumptions have to be made about how much the UK economy is going to grow between now and then.

Obviously, the more the economy is projected to grow the smaller the increase in spending between now and then appears, so policymakers have an incentive to make over-optimistic projections of GDP growth in order to get out of making painful reforms now.

This is extremely unfair in intergenerational terms, because all the risk of us not achieving the predicted levels of GDP growth is transferred to those in the future, who will have to pay more in taxes if spending ends up requiring a higher percentage of GDP than we think it will at present.

It also, to a certain extent, ties the hands of future generations, as they are forced to achieve those targets for GDP growth in order for the system to remain sustainable. This means they will have to maximize consumption, which is largely the goal of our economic system now, but may not be in the future, if, for example, an ecological collapse meant we desperately needed to make sustainability our main priority.

Is 2% a year still feasible?

The Office of Budgetary Responsibility (OBR) recently published their long-term outlook for the UK economy over the next 50 years, which included the following statement about growth: “we assume in our central projection that whole economy productivity growth will average 2 per cent a year on an output per worker basis, in line with the average rate over the past 50 years ”

What this means is that the government is proceeding on a basis where they assume the next 50 years will look a lot like the previous 50 years in terms of economic growth – a basic average of about 2% per year, which would probably fluctuate unevenly between particularly strong “boom” eras and relatively short periods of recession.

Under this regime, they go on to say, public expenditure on everything other than debt interest combined would go from 36.3% of GDP at the end of the current parliament in 2015 to 41.7% in 2061, an increase of 5.4% – £80 billion in today’s money. These increases will be driven by large rises in the costs of pensions, the NHS and long-term social care fuelled by the swelling ranks of the elderly.

Yet they have also prepared a projection in which the economy only grows at an average of 1.5% percent a year in the same period, in which case non-interest public expenditure would be 42.3% of GDP. This may not sound like a huge increase, but it would be equal to nearly £10 billion in today’s money, potentially pushing the total bill towards the £90 billion a year mark.

Is even this level of growth likely, though? Given that, socially and geopolitically the world is going to be very different in the next 50 years, there are a number of reasons why predicting we can hold spending at this level of GDP may be over-optimistic:

1) Changes from the past – In a number of ways, Britain enjoyed rosy conditions for generating economic growth during the twentieth century which are unlikely to be repeated over the next 50 years.

Growth of 2% a year during this period was achieved through the youthful endeavors of the baby-boomers, who are now ageing and being replaced by a smaller generation of younger workers; it gained an initial boast from the huge post-war reconstruction project; government borrowing was able to rise over the long-term, whereas now we will have to start paying it back, and North Sea oil was a strong source of revenue for nearly 25 years, but we are now a net importer of energy.

2) Changing distribution of global economic activity – The spread of globalization has seen the developing” world grow richer, and an ever larger proportion of global economic activity taking place outside the traditional developed” world of Europe, the US and Japan. The OECD estimates that by 2020 less than half of global GDP will be generated by its members, and this figure will then decline even further to just 43% by 2050.

There is a strong school of thought which argues the West will look progressively less attractive as a destination for investment because of its ageing population, shrinking labour markets and high costs of doing business, while many countries in the former developing world – especially the so-called E7” group of the seven largest emerging markets: China, India, Brazil, Russia, Indonesia, Mexico and Turkey – will be able to tap into large demographic dividends as they have millions of young, well-qualified workers.

The economist Richard Ehrman is a proponent of this view, who argued in his 2009 book The Power of Numbers: Why Europe Needs to Get Younger that “as developing countries become more sophisticated and their educational levels rise, we can expect more [service] jobs to follow their manufacturing predecessors to the low-cost, fast growing economies of the East and Latin America. It will not just be call centres that are sent offshore; highly paid experts like software engineers and financial analysts will be equally vulnerable.”

The UK has a younger labour force than most developed countries, but is still highly vulnerable to the ageing and slowing of the continental economies because they are our major trading partners. If Britain struggles to compete with China and India for business, the entire welfare state may become vastly more difficult to fund.

3) Reliance on immigration – Much of the UK’s economic growth over the last ten years has been fuelled by high levels of immigration, which Britain needs because it suffers from a shortage of highly-skilled workers, particularly amongst the younger generation.

More workers will be needed as the population ages to help fund public expenditure for retired people, yet at the same time the government is trying to cut back immigration because it seems to be politically unpopular.

However, much of Britain’s immigrant labour comes from the rest of the EU, particularly Eastern Europe, where immigration to the UK will have to remain unrestricted because of open-border policies which we’ve signed up to.

The UK is one of only three countries to have allowed unrestricted migration from the new member states that joined in 2004, which is part of the reason it attracted so many of them. Yet if other European countries were to allow unrestricted immigration, particularly Germany and France, there is a good chance, after they’d recovered from the present recession, that they would absorb a large proportion of these workers instead as they are nearer to their home countries.

If that happened, the British economy could be starved of competitively priced, well-qualified labour.

4) Reaching a tax ceiling – Government expenditure is not directly paid by economic growth; rather, it is funded through taxes on economic growth. Yet having a bigger economy does not necessarily mean that more taxes can be raised, because as the tax burden increases, tax evasion and the exploitation of loopholes are both likely to become more widespread.

There may even be a threshold level above which people are unwilling to pay any more tax, after which it becomes very arduous to collect higher amounts, and bearing in mind the political difficulty of any tax increase, assuming the economy will grow does not necessarily make the liabilities easier to pay off.

5) Experiences of other countries – Our prediction of 2% growth seems very optimistic compared to other countries who have traditionally out-performed us economically.

Axel Weber, who recently left his position as head of the German Central Bank, has argued that he doesn’t think Germany will grow by more than 1% a year in the long-term, and doubts anywhere in Europe will do much better than that either.

At the same time, in April 2011 Ben Bernanke, Chairman of the US Federal Reserve, said he thought US growth rates will be less than 2% a year, despite America having a reasonably favourable demographic profile.

There is also the example of Japan, which shows that economic growth and population ageing are related, as it saw a ‘lost decade’ of stagnant growth once its working age population began to shrink in 1996, which has pushed its current public expenditure to the brink of being unaffordable.

Japanese retirees have also been found to consume less than younger people, meaning GDP has grown more slowly as they’ve become a larger share of the population.

No excuse not to make reforms now

In the interests of future generations, it would make sense for the government to be a little pessimistic in its GDP forecasts, and forge ahead now with the reforms that will reduce the impacts of population ageing on those who will ending up paying them.

This would do much more to promote intergenerational fairness, giving future generations flexibility in the likely event that the country doesn’t achieve the treasury’s ambitious projections for growth.

Posted on: 17 July, 2011