The following is a revised version of the speech delivered by José Piñera at the 2nd European Resource Bank Meeting, Vilnius, October 14, 2005. José Piñera is Founder and President of the International Center for Pension Reform (www.pensionreform.org) and Senior Distinguished Fellow of the Cato Institute (www.cato.org).
I would like to thank the Lithuanian Free Market Institute for inviting me to Vilnius to address this meeting of the European Resource Bank. I strongly believe in the power of ideas, and I strongly recommend that people who share similar ideas about freedom should network and exchange experiences, because our goal should not be just to write books and make speeches, but to make a difference, to create a better world for everyone.
Let me state my two basic convictions on this issue in a very clear way. First, the pay-as-you-go (paygo), unfunded, pension system that is prevalent in Europe, America and most of the world, is going bankrupt. It is like the “Titanic” going directly toward the iceberg of demographics. And, regrettably, most European leaders - presidents, ministers, and politicians - are like the captain of the “Titanic,” dancing on the deck, but not telling the passengers the truth, nor changing the course of the “Titanic”. Second, parametric pension reforms like increasing the retirement age, payroll taxes, etc., may slow the speed of the “Titanic” going towards the iceberg but do not solve the basic problems of a system that is structurally wrong and flawed.
The good news is that the worldwide pension crisis has created a great opportunity to empower workers through public policy while at the same time advancing liberty.
Since in almost every country workers are already compelled to contribute a substantial proportion of their wages to paygo retirement systems, the transformation of those systems into ones in which wealth is accumulated in personal retirement accounts can bring about a new paradigm, a world of worker-capitalists.
I believe that the world would be a better place if every worker were also an owner of capital. Workers would benefit from the appreciation of assets in the long term and feel more connected to the overall performance of the economy. The interests of the workers would be more in line with the interests of those who manage and control those assets, there would be less disparities of wealth, and workers would place a higher value on strong property rights and the rule of law. Above all, workers would find a new dimension of freedom and dignity in their lives.
This was my guiding vision 25 years ago when, as Minister of Labor and Social Security of Chile, I had the responsibility of designing and implementing a then radical pension reform. Chile’s pension reform fully replaced the state-run paygo system with one of retirement savings accounts that are owned individually and managed by the private sector, and it has been a huge success.
It is important to note that pension reform in Chile was introduced as part of a coherent set of radical free-market reforms, with the understanding that implementing such changes simultaneously was the best way to increase economic growth and get the most out of each reform. As a result, the growth rate of the Chilean economy doubled from its historical level to around 7 percent a year for more than a decade. The average real rates of return on retirement accounts has averaged more than 10 percent since their inception in May 1981, and pension assets under management have grown to be around 80 percent of GDP.
However, the impact of pension reform in Chile has gone beyond impressive economic indicators. It has led also to a radical redistribution of power from the state to civil society and, by converting workers into individual owners of the country’s capital, has created a political and cultural atmosphere more consistent with free markets, democracy and a free society.
It should be added that in Chile the same rationale of the 1980 pension reform has been extended, although imperfectly, to the areas of health and unemployment, with individual insurance (health) or accounts (unemployment) managed by the private sector.
In the 1990s, nine other Latin American countries followed the path opened by Chile, and today some 60 million Latin American workers own financial wealth in their retirement savings accounts. In the late 1990s and in this decade several countries of Central and Eastern Europe joined the reforming club, and now around 20 million workers have individual retirement accounts in that area. Moreover, in January 2001, Sweden, once a model welfare state, allowed its workers to put 2.5 percentage points worth of their 18.5 percentage payroll tax contribution into an individual account.
It should be emphasized that the Chilean pension model is a comprehensive alternative to the social collectivism initiated by German chancellor Otto von Bismarck at the end of the 19th century, which was the model for the welfare states of the 20th century.
By cutting the link between individual contributions and benefits —that is, between effort and reward— and by entrusting governments not only with the responsibility but also with the management of these complex programs, the Bismarckian paygo pension system turned out to be the central pillar of the welfare state, in which the possibility of winning elections by buying votes with other people’s money —even with the money of other generations— led to an inflation of social entitlements, and thus to gigantic unfunded, and hidden, state liabilities.
Global demographic megatrends, such as longer life expectancy and reduced fertility rates, will accelerate the crisis of paygo pension systems, especially in mature developed economies such as those of Europe, the United States, and Japan. As former U.S. secretary of commerce Pete Peterson has observed: “The costs of global aging will be far beyond the means of even the world's wealthiest nations —unless retirement benefit systems are radically reformed. Failure to do so, to prepare early and boldly enough, will spark economic crises that will dwarf the recent meltdowns in Asia and Russia. For this and other reasons, global aging will become not just the transcendent economic issue of the 21st century, but the transcendent political issue as well.”
The Coming Crisis in Western Europe
In stark contrast to some of their neighbors to the east and in Latin America, the political elites in western continental Europe have so far been unwilling to engage in structural pension reform. For Europeans, that political paralysis will be disastrous if it continues, since the region's looming pension crisis is perhaps the most severe in the developed world. It is even possible that the pension time bomb may sink the euro in the long term.
The population in Europe is aging and declining. A trend that could have been perfectly manageable with foresight could turn into a catastrophe given the increasing unfunded liabilities arising from paygo public pension programs, now more than 200 percent of GDP in France and Italy, and more than 150 percent of GDP in Germany. This situation is especially difficult in a continent where entitlements are deeply entrenched in a welfare state culture.
The European Commission recently stated, "There is a risk of unsustainable public finances in some half of EU countries. Belgium, Germany, Greece, Spain, France, Italy, Austria and Portugal are on this black list.” Furthermore, the monetary affairs commissioner of the European Union warned, "There is only a limited window of opportunity for countries to get their public finances in order before the budgetary impact of aging takes hold as of 2010" (EUobserver.com, May 21, 2003).
Some European countries have begun to recognize the fiscal consequences of these demographic imbalances. But regrettably they seem to believe that changing some key parameters of the PAYGO pension system will solve the crisis. In June 2003, France's Prime Minister Raffarin eloquently spoke to his country’s National Assembly of the need for “lucidité demographique” and managed to eliminate some blatant privileges of the public workers pension system. These measures partially correct the abuses of the system but not its flawed roots. The recent German pension reform, basically tax credits for supplementary savings, were a failure because too many people simply cannot save extra money after paying huge payroll taxes. Italy, the country with the lowest fertility rate in the world, has annual public pension outlays of around 14.5 percent of GDP. Italians, who already face 33 percent payroll taxes for pensions, would need to increase those taxes to 48 percent to pay the benefits promised to the elderly.
Even though European leaders seem to believe that so-called parametric pension reforms will be sufficient to solve the crisis, there are three main reasons that conspire against that goal. First, the political viability of some of these reforms among members of the European Monetary Union is clearly asymmetrical. For example, it may be possible to raise substantially the legal retirement age across the board in a corporatist country like Germany once consensus is reached at the top. But in France, where the recent attempt at marginal adjustments in this area for government employees led not only to long and crippling strikes but even to the support of a majority of the population, that may prove impossible.
Second, it is probable that the most decisive “parametric” change—postponing the age that makes a worker eligible for full state pension benefits—will have unintended consequences. For example, it may induce changes in the behavior of those workers asked to extend their working lives. In countries with extensive welfare programs and lax disabilities procedures, that would simply mean shifting the source of state expenditure to another program or ministry. It must be kept in mind that the rigid European labor laws not only keep the unemployment rate high overall, but also make it especially difficult for older people to retain their jobs, or get new ones, since wages cannot adjust downwards to keep pace with declining old age productivity.
Finally, measures like postponing the retirement age, reducing benefits, or increasing payroll taxes entail a decrease in the already minimal “rate of return” for these contributions, thus leading eventually to a young worker revolt, through voice (strikes, etc.) or exit (leaving the system or even the country). Those measures mean an increase in the existing “rate of return gap”, making paygo systems even less favorable when compared to private savings alternatives.
Funded versus Unfunded Europe
So, a division is emerging between what can be termed a "Funded Europe" and an "Unfunded Europe." The first group comprises countries with large private pension systems (Britain and The Netherlands), those that have recently introduced personal retirement accounts and could go even further (Sweden and Poland), and those with such sound public finances that are able to “fund” the paygo system with general tax revenues (Ireland and Luxembourg). The second group comprises the four big countries that concentrate the bulk of EMU population and GDP— France, Germany, Italy, and Spain—and all the rest with unfunded paygo systems.
“Unfunded Europe” leaders may want to follow the old Latin American recipe—namely, devaluation, so that the ensuing inflation reduces the purchasing power of benefits. But “Funded Europe” will probably oppose devaluing the euro. A clash may ensue amidst the centers of decision making in Europe, especially within the board of the European Central Bank. Of course, this perspective may be behind the reluctance of increasingly “funded” countries like Britain, Denmark, and Sweden to join the eurozone.
More than renewed armed conflicts among European countries, as Martin Feldstein has envisioned, I believe that the prospects are for intense, exacerbated, maybe even violent, age wars. The young resenting the confiscation of a substantial part of their hard-earned salaries; the old living in permanent fear of the growing budget deficits and the possibility of substantial benefits cuts, either directly or through inflation.
It cannot be denied that European workers in the paygo pension system are like passengers on the Titanic. By destroying the essential link between effort and reward, between contributions and benefits, this collectivist system encourages what Bastiat called “legal plunder.” And by making the finances of the system dependent on fertility rates and life expectancies, it has been relegated to the wrong side of the European demographic megatrend of the 21st century toward aging and declining populations.
Some people think that massive immigration into Europe could postpone or even solve the problem. That is not so for several reasons. First, an economic one. Massive immigration of low paid workers would exacerbate the unemployment problems and reduce wages, diminishing the possible tax collections from payroll taxes. Second, the reckoning problem. Those workers will pay more taxes during their working lives, but they will live to collect benefits, so it is a postponement of the pension time bomb. Third, since the great wage differentials are with North Africa, it is impossible to disregard the problems of assimilation and religious tensions between largely Islamic immigrants and the rest.
European Integration versus the Bismarckian Welfare State
The way out is to introduce personal retirement accounts that re-establish that essential link between effort and reward and move toward defined-contributions rather than defined-benefits pension systems. Already 20 countries have followed this path, including important European ones like Poland and Sweden.
A system of personal retirement accounts would also improve labor mobility, another key to a well functioning monetary union. And, if complemented with a reform of the disability system, it would enlarge the available labor force and reduce wasteful government spending.
The prospects of the euro, and of European integration, would be much better if one of the big countries of the eurozone were to begin a transformation in this direction, leading the way for the rest to follow. Ultimately, if Europeans, Americans, or Japanese do not want to have enough babies, they will have to accumulate enough euros, dollars, or yen in personal retirement accounts.
Whatever the merits of its introduction, the euro is already a fact and its demise could weaken the noble and visionary effort of a common economic space in Europe that has brought prosperity and ensured peace.
If Europeans want to keep their common currency, they will have to abandon the Bismarckian pension paradigm and, while keeping a government-financed safety net, begin moving toward a comprehensive retirement system based on ownership, individual freedom, and self-reliance.
