Population ageing calls productivity growth forecasts into question

The new long-term projections of the European Commission predict an even stronger relative ageing of the population than before, but also a substantial increase in productivity growth in the coming decades. The latter will ensure that the potential growth of the European economy is maintained and that the increase in ageing-related costs can be relatively contained. The achievement of this cannot, however, be guaranteed. Productivity growth has not recovered since the financial crisis. This has been due in part to the patchy dissemination of new technologies and the sub-optimal distribution of production factors. However, even if these problems were to be resolved, the projected acceleration in productivity growth is not certain. After all, the ageing of the (working-age) population is itself a factor hampering that growth. The Commission projections ought therefore to be treated with caution so as not to underestimate the ageing costs.

Ageing bites harder

Every three years, the European Commission updates its long-term projections for demographic and certain macroeconomic variables in its ‘Ageing Report’, based on which it forecasts the costs of ageing in the coming decades. Several of the results from the 2015 edition were discussed at length in our research report (2017) on socio-demographic trends within the EU. The underlying assumptions and forecasts for the 2018 edition of the Ageing Report were published at the beginning of this year. The Commission estimates that the ageing of the population will bite harder than projected in the previous edition. According to the new forecast, the old-age dependency ratio - defined as the ratio of the population aged 65 or over to that aged 20 to 64 - is projected to be 1.6 percentage point higher by 2060 for the EU as a whole (56.8% compared to 55.2%). On the one hand, the higher forecast ratio reflects a larger increase in the population over 65 years of age. On the other, it mirrors a sharper contraction in the working-age population. The ageing of the European population will be felt more intensely as a result.

Potential growth nevertheless stronger

One important consequence of population ageing is the negative impact on potential output and growth in the European economy. The potential gross domestic product (GDP) of an economy indicates the level of output that is sustainable in the longer term. Potential output depends on the availability of production factors - labour and capital - and their efficiency or productivity. Ageing impacts both factors negatively, leading for instance to a smaller volume of available labour. The Commission predicts a fall in both the absolute number and relative proportion of the working-age population. The contribution of the quantity of labour to potential growth in the EU will therefore turn negative after 2020.

All the same, the Commission forecasts for potential growth do not suggest any substantial slowdown. On the contrary, following a limited decline between 2020 and 2030, European potential growth might even accelerate slightly towards an annual rate of 1.5% compared to 1.3% in 2016. The Commission also projects an increase in potential growth per capita. As the contribution from the quantity of available labour is projected to be negative, this higher forecast potential growth is entirely attributable to an increase in forecast productivity growth. The Commission expects the growth in labour productivity per hour worked to accelerate from a mere 0.6% in 2016 to a peak of just over 1.6% in 2050. The average annual growth rate of labour productivity between 2020 and 2070 would then work out at 1.5% (figure 1). According to the Commission, most of this projected acceleration in productivity growth will be driven by more efficient utilisation of the factors of production – i.e. through higher growth in total factor productivity (TFP).

Figure 1 - Acceleration in potential growth forecasts entirely driven by stronger productivity growth (labour productivity growth per hour worked, annual % growth, EU28)

Source: KBC Economic Research gebaseerd op Eurostat; EC 2018 Ageing Report – Underlying assumptions & projection methodologies (2017)

Overly optimistic?

The Commission’s rosy forecasts are far from self-evident. Productivity growth has been significantly lower since the financial crisis than it was in the period before (figure 1). Consequently, the current potential growth level is still lower than it was in the pre-crisis era. Research by the OECD and ECB has identified two significant causes for weak productivity growth in recent years. First of all, TFP growth was extremely lacklustre. This had nothing to do with any lack of technological progress, but rather with the patchy dissemination and valorisation of innovations. Companies that are lagging behind are failing to implement technological improvements sufficiently within their production process. Secondly, the ECB notes that the allocation or distribution of production factors is not always optimal. According to the ECB study, the inefficient distribution of capital between the most and the least productive firms has actually increased in recent years.

Both of the causes of weak European productivity growth in the past few years can and must be addressed in order to boost that growth. The principal focus ought to be on the dissemination of knowledge and innovation, which requires a competitive business climate. Lack of competition can lead to a situation in which certain companies don’t feel the need to raise their productivity. This can give rise in turn to so-called ‘zombie companies’ - firms that are chronically unable to cover their costs and generally record low productivity figures. At the same time, productive businesses must be provided with sufficient growth opportunities through well-functioning capital, product and labour markets.

However, even with measures of this kind, achieving the optimistic forecasts for productivity growth is not guaranteed. This is because there is one key factor that the Commission does not include in its forecasts, namely the impact of population ageing on productivity growth. Although substantial differences exist between individuals, the literature suggests a general decline in productivity as workers grow older, due to waning physical and mental capacity. The increasing proportion of over-50s in the working-age population might therefore hamper macroeconomic productivity growth. Consequently, the Commission’s forecasts ought to be treated with caution, because if productivity growth is overestimated, the costs of ageing could turn out much higher than anticipated.

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