It is difficult to exaggerate the scale of the population crisis in the West. In previous times in economic history, there have been calamities that have wiped out large parts of the population. During the ‘black death’ plague, for example, fourteenth century Europe lost between one-quarter and one-third of its population. That crisis led to an increase in wages for those who remained, though there were other huge economic and social difficulties. However, what we are facing today is quite different.

The West has set up pensions and healthcare systems that require the working generation to pay taxes that provide social insurance benefits for the retired generation. In other words, yesterday’s young were able to vote themselves promises of pensions and healthcare to be paid for by today’s young. Given the fact that a very high proportion of spending on healthcare occurs in the months before people die, healthcare and pensions can be seen as two aspects of one and the same problem.

At times, these promises have been scaled back. However, pressure from greying electorates has actually led governments to increase the scope of taxpayer-financed pensions and healthcare benefits that are to be given to older people financed by taxpayers. In the US, for example, George W. Bush hugely increased healthcare entitlements and, in the UK, our government has promised to increase pensions even faster than average wage increases. In the UK, between 2007 and 2014, the incomes of pensioner households rose by 10% more than inflation whilst the incomes of those of working age fell by 4% after inflation. The coalition and Conservative governments have quite deliberately and transparently protected pensioners – even better-off pensioners – from welfare cuts and the current government is still increasing pensions much faster than inflation.

The underlying problem is that the current older generation did not accumulate capital which would have financed their pensions and healthcare in later life – though many might have presumed that their social insurance taxes went into some kind of “fund”. Instead, they made promises to themselves that would be fulfilled by the generation of workers that was coming behind.

Unfortunately, that generation of workers is not big enough. Most Western countries have been reproducing below replacement rates so that, in the long term, population decline is setting in. Population decline manifests itself at first in the form of fewer young taxpayers available to pay the pensions and finance the healthcare of the older generation. In addition to shrinking birth rates, older people are living longer.

The problem is set to get worse. Germany’s population is projected to fall by 10 million in less than 50 years, with nearly all of this fall concentrated within the working population. This is even after allowing for inward migration. On average, in many countries, families are having only slightly more than one child (for example, 1.4 in the case of Italy) and populations are in danger of collapse with far fewer workers supporting more pensioners. Portugal, Poland, Slovakia and Croatia are projected to see population falls of up to a quarter within the lifetime of today’s forty-year-olds. Outside the EU, Russia and Japan may see population implosion. Even over a shorter period, we can expect to see considerable population decline, and this is very much concentrated amongst the younger age groups.

In most countries, little has been done to adjust pension benefits to this new situation of a thinner base of taxpayers and people living longer, though we have seen limited reform in some countries through raising state pension ages.

Also, healthcare is becoming more expensive. In real terms, costs are rising. Average annual growth in healthcare costs outstripped national income growth in all major European countries except Ireland between 1960 and 2005 leading to more than a doubling of the share of national income spent on healthcare. From 2006 onwards, the picture has been more complex as the financial crisis has led to spending restraint in some countries and also a slowdown in national income. However, the basic drivers of the process have not and will not change.

Any one of these problems could cause significant fiscal problems. The three problems combined lead us to a place where we have never been before. Indeed, whether you look at Asia (South Korea or Japan, for example), the US or Europe, it is difficult to see how governments can meet all the promises that they have made.

What can be done? Estimates of the extent of the fiscal crisis have been made. The most sophisticated suggest that many Western countries will have to cut social protection spending programmes (that is, health and welfare spending) by about one half in order to balance the books in the long term. Countries such as Chile, Estonia, Australia and Switzerland are in a better position because of either low government debt or pension systems funded by saving, or a combination of both.

If governments are going to cut spending to this degree, it will mean reneging on promises to future pensioners by raising state pension age, means-testing benefits or rationing healthcare.

Governments can also stop the problem getting worse by promoting the pre-funding of pensions and healthcare. People should save for at least part of their pension and future healthcare needs during their working life with government provision being appropriately scaled back.

We also need to expand the tax base. In the UK and the US, much of the work here has already been done. Employment rates are pretty high. However, in much of the EU, labour market participation is much lower. On average in the EU, taxes paid by the employer and employee sum to a total equal to nearly 70 percent of take-home wages for low paid workers. When people move from unemployment into work the amount of additional income they receive after taxes is therefore very low. It is, sadly, not surprising that youth unemployment rates are 20 percent in the EU. Given this, EU countries need to radically liberalise labour market regulation and reduce taxes – difficult given the demographic pressures – to get people back to work.

Finally, there is the question of whether technology can be the answer. Almost certainly, it can at least provide part of the answer. Health care costs have been rising partly due to new technology. But, this is not destined to go on forever: it depends on the technologies that are developed. A discovery that leads to more people surviving strokes in a disabled state, for example, might raise costs; a cure for arthritis, on the other hand, might lower costs. It is quite possible – indeed likely – that household monitoring devices could lower healthcare costs substantially by keeping people comfortable in their own homes so that they do not have to be institutionalised in hospitals (where, in the UK, they are likely to pick up infections too). We need a healthcare system that can take advantage of innovation.

What might such a healthcare system look like? It would have more funding in the hands of the patient – in cash and not through insurance policies. The government might provide this cash to the less well off, but it is important that patients are making more choices so that it is their preferences that are reflected. Even where the state is funding healthcare, we need more private provision so that there is experimentation, innovation and an incentive to use resources and technology efficiently. It is not inevitable that healthcare costs will continue to rise in real terms, but we do need a market-based system if we are to take advantage of innovation in both improving patient experience and reducing costs.

Some argue that the government has to fund research to promote innovation. I do not believe that. However, what is clear is that, if the funding and provision of healthcare is entirely controlled by government, adoption of innovations will not become widespread. Just imagine, if the developers of information technology innovations and the users of communications technology had been nationalised companies. Where would those sectors be today? The way in which healthcare is provided is different in different countries – in the UK, we are at the extreme end of the spectrum. Throughout the world, though, government involvement in healthcare needs to be reduced if innovation is to be harnessed.

 

This article was first published by the BlackRock Retirement Institute.