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Europe's Retirement Blues

by L. Jacobo Rodríguez

This article appeared in The Journal of Commerce on February 5, 1998.

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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 goingbankrupt. In 1996 the Organization for EconomicCooperation and Development estimated that the netpresent value of future social security commitments as apercentage of gross domestic product amounted to at leasttwo and a half times the size of GDP in 9 of 13 EUcountries (figures were not available for Luxembourg andGreece), and the net present value of the unfundedpension liability exceeded 100 percent of GDP in 6 ofthose 13 EU countries.

In a pay-as-you-go system, the government taxes activeworkers to pay for the pension benefits of retiredworkers, thus severing the link between effort andreward. Contributions to social security are a tax on theuse of labor, not an investment. As the elderly become alarger part of the EU's population, the ratio ofactive workers to retired workers decreases, which meansthat European workers will have to pay even higher taxesthan they are paying today to finance social securityprograms. With 18 million workers unemployed (about 11percent of the EU's labor force), the negativeimpact of high payroll taxes on employment is alreadyevident. Consequently, any policies that further increasethe cost of labor would be politically unpopular andeconomically unsound.

A reduction of benefits would be just as unpopular andinsufficient to stave off the eventual bankruptcy of thesystem. Reducing benefits would also be unfair to seniorcitizens, most of whom, because they have been deprivedof the satisfaction and dignity of providing for theirown retirement, depend on the government for theirretirement income. Finally, from a politician'spoint of view, reducing pension benefits is tantamount topolitical suicide because senior citizens make up about16 percent of the EU's total population (and, ofcourse, a higher percentage of the voting population).

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.

The third possible solution for EU countries might beto inflate or borrow their way out of the crisis. But theMaastricht criteria for monetary union do not allow anymember country to have an inflation rate 1.5 percentagepoints higher than the average of the three lowestinflation rates of member countries. And, although theimplicit debt in pay-as-you-go pension systems is notincluded in the criteria for the public debt, the marketpunishes countries with profligate governments intoday's global economy.

Government-friendly measures will do little toalleviate the crisis in social security and much to spawnintergenerational conflict in the near future as fewerand fewer workers are asked to support more and moreretirees. But that conflict would be avoided ifcontinental Europeans were to implement a reform theyhave so far been reluctant even to consider:privatization.

The private system of individual pension savingsaccounts has worked very well in Latin America,especially in Chile, where it was first implemented in1981. Critics of fully funded private pension systemsacknowledge that those systems provide better returns,even as they contend that the transition would be toopainful in industrialized countries to make such accountsa viable alternative. It is worth noting, however, thatsome Latin American countries have successfully made thetransition under economic circumstances that are muchworse than those facing any EU nation today.

The privatization of social security will strengthencivil society in the EU in the same way it has in thoseLatin American countries that have followed Chile'sexample. Social security there has ceased to be aredistributionist program under which different groupscompete against each other in the political arena todetermine which group benefits at the expense of theothers. Instead, privatization has established a directlink between individual efforts and rewards. In addition,a large percentage of the population, formerlydisenfranchised, has obtained visible property rights andnow has a stake in the economy through pension savingsaccounts.

The European Union has greatly expanded its traderelations with Latin America. Now it's time forEurope to import a Latin American social policy idea,pension privatization, that offers the only opportunityfor European workers to enjoy a decent retirement. Infact, the United States would also do well to learn fromour Latin American neighbors.