Europe’s bigger crisis waiting to happen
By Kathleen Brooks. The opinions expressed are her own.
The markets always suffer from a chronic case of short-termism, but once a sovereign debt crisis takes hold it is very difficult to reverse. Investors may be concentrating on Greek, Irish and Portuguese funding needs for the next 24- 36 months now, but it won’t be long before investors start to scrutinise longer-term liabilities that are currently being clocked up for the next 10,20 even 30 years.
The bigger beast that threatens Europe’s solvency is the demographic and entitlements crisis. While a lot is known about Europe’s aging population, the scale of the problem and its urgency are not well understood.
The IMF predicts that Greece will have the second highest growth in pension costs as a percentage of GDP in the G20 by 2030. Spain and Belgium aren’t in great shape either. Interestingly, by 2030 Italy and Germany will actually see their pensions’ costs start to fall, but that is because their populations are aging so fast that the bulk of their pension spending will be done in the next 10-15 years.
In Germany and Italy the demographic damage is done. Research from Eurostat predicts that by 2040 there will be less than two people of working age for every retired person in Germany and Italy that compares with just over three today. In France things are slightly better as there will be just about two workers for every retired person. These statistics tell a bleak story, with this type of demographic shift it is inevitable that living standards will deteriorate in the next decade or so.
The fiscal crisis of the future could also have a domino effect. Once investors realised there was an enormous hole in Greece’s public finances they started to punish Ireland, Portugal, Spain and even Italy saw its bond yields rise. In the future investors may start to punish the credit markets of those countries with poor demographics.
To get a sense of how large this problem is it’s worth putting it in perspective. The cost to bailout the banks after the 2008 subprime crisis cost 1.1 trillion dollars globally. The cost to bailout Europe’s periphery is 700 billion euros so far and counting. However, the cost to bailout the union from an entitlements crisis would be on a far larger scale and could bankrupt the entire currency bloc.
While investors seem fairly confident that Germany will act as fairy godmother and bailout the peripheral nations until the current problem goes away, it won’t be able to play a similar role in the next crisis. Germany has some of the worst demographic stats in the world, let alone the euro zone, so while it remains in a healthy financial position right now, it is inevitable that it will draw down on its fiscal surpluses in future to pay for its aging population.
The challenge of dealing with an aging population – by 2060 in the E.U. the number of 14-year olds and under will have fallen nearly 10 percent, while the number of people over 80 will have tripled – has a social impact as well as a financial one. Old age poverty is a growing phenomenon in the Western world, especially for women who live longer and typically have much smaller pension pots than men at retirement.
From a financial perspective, who is going to want to lend to a country that has to spend its revenue on health care and pensions rather than infrastructure and investment? This will make it more expensive for countries already nursing huge deficits to finance themselves going forward.
The focus of this article is the euro zone, but that doesn’t mean that the U.S. and the UK don’t having aging populations it is just that Europe’s problems are more acute. The U.S. and the UK both have slightly higher birth and immigrations rates than the currency bloc, which might give them some protection in the future.
As mentioned above the problem with a sovereign debt crisis is that once it takes hold it’s hard to reverse. They also tend to have a snowballing effect, but Europe’s demographic crisis is more like an avalanche. It won’t be long before investors start to worry about long-term liabilities and how western nations with high debt-to-GDP ratios will fare when the cohort of retirees in their populations start to rapidly increase.
To conclude, one of the main consequences of Europe’s demographic crisis is that the notion of sovereign debt as a risk-free asset class dies out. Since sovereign debt has been at the centre of our financial system for decades its demise could make the whole investment universe more risky.
Image — Greece’s Prime Minister George Papandreou (R) and Finance Minister Evangelos Venizelos attend a session in the Greek parliament in Athens June 29, 2011. REUTERS/Giannis Liakos