Demographic change and Decarbonization – the Dual Challenge for Europe

Europe’s economies are facing a number of far-reaching changes in the coming decades. These undoubtedly include demographic change and ecological transformation. As both processes are occurring simultaneously, there is considerable pressure for both economies and societies to adapt.

World population growing, Europe shrinking

Europe is the only region of the world where the population will decline in the coming decades. This population reduction is already beginning: Europe will have a smaller population than in 2020 as early as 2030.

More critical than population shrinkage is the change in the age structure. A central indicator for measuring the age structure of society is the so-called old-age dependency ratio. It indicates how many people aged 65 and older there are for every 100 people aged between 15 and 64.

Somewhat simplified, this ratio can also be interpreted as the pensioner ratio. This interpretation is suitable because the people aged 65 and over are of retirement age, and 15- to 64-year-olds are working age.

Europe currently has the highest old-age dependency ratio and will remain the oldest region in the world in the future. However, within Europe, there are considerable differences: In France, Sweden, and the United Kingdom, the increase in the old-age dependency ratio is moderate.

This is mainly because there are relatively high birth rates in those countries. On the other hand, there is a sharp rise in the old-age dependency ratio in southern European countries due to low birth rates but also emigration trends.

An aging population threatens prosperity

Population aging has a number of negative consequences for a society’s economic prosperity. Compared with economies with a young population, there is a risk of a loss of international competitiveness:

• A demographically induced shortage of skilled workers increases wages and therefore costs of production for companies. The same applies if non-wage labor costs rise due to higher contributions to pension insurance and health insurance.
• Empirical studies also show that both labor productivity and the innovative capacity of companies and economies decline as the workforce ages.

Hence, the aging of the population has a dampening effect on economic growth. For the government, this means lower revenues. At the same time, it has to spend more on pensions, health care, and long-term care. The state’s scope for action in other areas declines. This is problematic because the state’s role in the context of climate protection will increase considerably in the future.

Decarbonization as a new public task

The EU has set the goal of being CO2 neutral by 2050, requiring a much more significant reduction in carbon emissions over the coming years than has been the case to date: It requires almost a threefold increase in annual reduction volumes.

Decarbonization demands extensive measures to transform the economy and society. All Businesses, consumers, and the state are all challenged. The state importantly has two central areas of responsibility:

1. It must increase its investment in low-emission infrastructure. This applies to transportation, public buildings, and much more.
2. Because ecological transformation is a knowledge-based activity, it requires high skills, especially in the areas of technologies, information technology, natural sciences, and so on. This also requires government spending in the entire education sector and in research and development.

Ecological transformation places additional demands on the government’s expenditures. These increasing demands are met by a higher level of debt (which arose during the Corona pandemic), and by the aforementioned fiscal requirements of the aging of the population. How can the government finance all this? Of crucial importance for the state’s ability to act in the future is how to deal with demographic aging.

Options for action in the area of financing

The government can raise social security contributions and increase its revenues. However, this has a negative impact on the labor market: Gross wages paid by companies increase.

Therefore, companies demand less labor. Net wages received by employees fall, and the labor supply of private households declines. The result is rising unemployment, which has to be financed.

Second, the government can reduce benefits in the area of social security. However, benefit cuts have little appeal in society. Moreover, in a society where voters are getting older, it won’t be easy to get a political majority for such measures. One option is to strengthen private pension provision. However, it must be taken into account that low-income households have the greatest need to top up their future pensions and the fewest financing possibilities.

Finally, the higher expenditures for pensions and health could be financed by tax revenues. But this means that these tax revenues are no longer available for investment purposes, which are necessary for the ecological and digital transformation.

All three activities, therefore, have disadvantages. It is thus better to take measures that increase the numerical ratio between the working population and pensioners.

Increasing employment

In essence, the aim is to increase labor force participation in the EU. Three main areas come to mind here:

1. Improving the compatibility of family and work. This can increase the labor force participation of women. It relates to better care options for children but also support for caring for the elderly.
2. An improvement in people’s health because healthier people are available to the labor market for longer. This also means that the labor force participation of older people will increase, and working people will retire later.
3. An increase in the level of education. Better educated people not only have higher productivity. They also have better opportunities in the labor market, which ensures a higher level of employment.

All these measures require investments in the present. However, they are worthwhile: with higher employment, the economy produces more goods. This provides the material conditions needed for the ecological and digital transformation of the EU.

Outlook

Europe’s economies are facing enormous structural changes. Particularly problematic is the fact that adjustments to societal aging, ecological transformation, and digital transformation must occur simultaneously.

Massive structural change is always associated with adjustment costs that must be shared fairly in society – otherwise, there is a risk of social protests and political blockades. It is also clear that waiting is not an option because then the social costs will be even greater.