European politics is in a mess, and many of the institutions and values that we have learnt to cherish are being threatened by new and radical political initiatives. Aggressive nationalism and right-wing populism have assembled an agenda that in the eyes of many combines the worst ideas of the old-fashioned left and right. From the (paleo-)left there is a distrust of open markets, free trade and international integration; and, from the (paleo-)right there is aggressive nationalism or even racism, anti-feminism and overall hostility to modernist individualism.

The cause of this new political ‘nastiness’ has been ascribed to economic phenomena. Globalisation has brought benefits to the elites of rich countries as well as to the rising middle class of formerly poor countries. In the jargon of economists, the positive labour supply shock due to China’s modernisation has exerted downward pressure on labour costs. This has contributed to sluggish wage growth in low-skilled tasks (Chusseau and Dumont 2012; Dabla-Norris et al. 2015). Of course, technology has probably also contributed to the widening wage disparities. This combination of technological advances and competition from Asian low-wage economies has, in many countries, decimated traditional manufacturing jobs. According to many accounts, this disruption of traditional communities has been the main source of discontent and has thereby contributed to the ascent of populist and nativist politics.

At the same time, the public finances of many European countries are perennially weak. Since 2008 this problem has been exacerbated by the financial crisis, but there was a structural issue even before the long recession that began in that year. Economic growth will to some extent alleviate this problem, but, as the European Commission’s ageing reports have made clear, many European countries are in the danger zone of fiscal unsustainability. The European working-age population started to shrink around 2010 and will continue to shrink for at least three decades to come (European Community 2015).

In this article I shall argue a point that has been underemphasised in European political debates. The point is that demographic change in the form of ageing can play and has played a large, though indirect, role in the current European economic and political malaise.

Supply-side policies are a rational response to ageing

At some juncture in their histories, most successful societies reach a point at which longevity is increasing while fertility is shrinking. This usually entails a deterioration in the dependency ratio. There is nothing inherently wrong with this: longevity is something most of us like, and it is good that the global population is becoming more stable. Yet this transformation of the age structure implies a problem for public finances in countries with large public sectors. This is so because an individual’s net contribution to the public purse varies considerably with age. We consume public services as children and young people, contribute to them while working, and again become net consumers of public resources when old. As the number of pensioners increases and the number of working-age people shrinks, the public sector deficit inevitably increases, even with unchanged policies and unchanged welfare entitlements. This is mostly due to two factors: the increase in demand for publicly provided and age-correlated health care and elderly care services, and, of course, the consumption of pension assets.

There are differences between countries as to the severity of this challenge for the public finances. The responsibility of the public sector for health care and elderly care expenditure varies, and the same is true for pensions. In some countries, the provision of pensions is formally a part of the general government finances, while in others it is a private arrangement; it is also common that a basic pension insurance is publicly provided, which individuals are free to top up with additional private pension arrangements. Be that as it may, it is generally true that the ageing population is affecting the sustainability of public finances quite significantly in most European countries (European Community 2015).

The European working-age population, as measured by the number of 20–64 year-olds, started shrinking in 2010 and this trend will continue until the 2050s (European Community 2015). This downward trend is quite slight and, by itself, is an undramatic supply-side shock. However, from the point of view of sound public finances, this trend is significant. The European politicians who learnt their political skills in the decades following the Second World War became accustomed to an economic environment in which it was quite risk-free to increase public expenditure. The need to finance new spending programmes was easily met when the work force was growing. This was the (somewhat hidden) material basis for the economic optimism of the Keynesian era. We know now that, from a demographic point of view, this phase of ambitious welfare policies was quite a special one. The large cohorts born immediately after the war were active in the labour force, while life expectancy had not yet increased markedly. Thus there was a lot of leeway for increasing public expenditure.

As this special phase is now definitely over, European welfare policies must adapt to a more austere and constrained policy environment. In a demographically stable economy, there is no similar scope for increasing welfare entitlements and publicly provided services such as education and health care. Furthermore, for many countries, the specific phase of transition to the new equilibrium poses an ‘extra’ policy dilemma, since the large cohorts born after the Second World War will soon be old and retired.

With the workforce shrinking relative to the number of pensioners, the only sustainable way of stabilising the public sector’s finances is to increase the number of employed individuals. In other words, reforms that increase the supply of labour become necessary to ensure the sustainability of the public finances. Policymakers can, to some extent, alleviate the pressure on public finances by increasing taxes or cutting expenditure, of course. However, the scope for those two lines of defence is limited. On the one hand, tax increases that are acceptable to the electorate tend to be those that, according to many studies, hamper economic growth. Welfare expenditures, on the other hand, are quite solidly entrenched in the political preferences of the European electorates. Therefore, the main policy reaction to the deterioration of public finances must be an increased supply of labour. The severity of these policy challenges is well emphasised by Börsch-Supan et al. (2014).

The supply-side reform agenda

A rational reform agenda to increase the supply of labour consists of many elements which to varying degrees have been adopted by policymakers in different countries:

  • raising mandated retirement ages,

  • trimming unemployment benefits and social security entitlements and introducing conditionality and workfare to make it economically more attractive to work,

  • reforming labour legislation and wage bargaining systems to reduce structural unemployment, and

  • encouraging work-based immigration.

Such policy measures are precisely what Europe needs to counteract the effects of ageing. Those countries that have had the political will to undertake such reforms have clearly reaped a lot of benefits, even during the economically difficult period since 2007. The UK after Thatcher and Blair, Germany after Schröder and Sweden after the reforms of the Reinfeldt administration (2006–2014) have exhibited robust employment growth [see Dölvik and Martin (2015) for accounts of the reform experiences of various European countries].

However, many such policies have probably also contributed to the political strength of populist parties. More stringent unemployment insurance, for example, may be a resourceful and adequate reform, but such reforms are resented by working-class voters, who are then more easily tempted by populist parties. Many European countries suffer from high structural unemployment rates, meaning that unemployment seldom falls below 6%–7%, even in economic booms. In these situations it is difficult to argue for supply-enhancing reforms when there is ‘already’ a lot of domestic unemployment. Economists can, of course, point out that according to standard economic models the unemployment rate does not depend on the size of the labour force. Yet this is a complicated expert argument and it is therefore politically difficult, even for responsible policymakers, to argue for supply-side reforms when unemployment is high. In Germany, the justly celebrated Hartz reforms have led to strong employment growth and low structural unemployment, but they also initiated a lasting decline in support for the Social Democrats (SPD, Sozialdemokratische Partei Deutschlands). Instead of voting for the Social Democrats, many frustrated working-class voters have set their hopes on new nativist and populist political alternatives such as the Alternative for Germany (Alternativ für Deutschland).

No political prizes for good economic policy?

Moreover, of course, the aforementioned reform route regarding work-based immigration has become a politically delicate matter in many countries. For many economists and policymakers, the idea of increasing work-based immigration is a well-motivated and adequate way of tackling the problem of insufficient employment. Many probably also believe that the political success of liberal immigration regimes ultimately depends on whether the labour market functions well. If the answer is yes, immigrants will be duly integrated into the host society and in the long run everybody will be better off thanks to immigration.

The UK is an example of a flexible economy that has successfully tapped into the European and international skills markets. Unemployment is now under 5%, and a large part of British economic growth and employment growth can be ascribed to successful immigration. Employment has grown healthily, at a pace of about 1.6% per year during the last five years (2012–16) (OECD 2016). This is why the Brexit referendum result is such a shock and, in the eyes of many commentators, has altered assumptions about what is politically possible. I do not know of any economic analysis or other well-argued document that would vindicate the idea that immigration has been an economic burden for the UK. On the contrary, most serious economic analyses suggest that work-based immigration has been beneficial for the UK’s economic growth, and that the net effect has even been beneficial and probably will be beneficial for the public finances as well (see UK Government, Office for Budget Responsibility 2015). Inasmuch as there have been negative effects on domestic wages, these have been very small. Yet, against all these rational facts, the British public has voted to leave the EU, and the main motive is to reduce immigration. It is hard to tell to what extent the result was due to poorly informed voters. It is also perfectly possible that they just do not like migration and are prepared to pay the price for this dislike in the form of weaker economic growth and weaker public finances.

Germany, with its flexible post-Hartz labour market, has been able to sustain a moderate unemployment rate, even after the macroeconomic shock of 2008, in spite of it being an attractive place for many migrants from both within and outside the EU. Germany’s labour force has grown every year during the current decade, and so has employment, albeit at a slightly slower pace than in the UK. Germany’s unemployment rate is also under 5%, thanks to the muscular Hartz reforms undertaken from 2003 onwards. Yet even in Germany, with its obvious and almost splendid economic record in recent years, a powerful wave of protest politics against immigration has emerged in the form of support for the Alternative for Germany.

The same goes for Sweden, where, even during the long recession, employment growth was quite satisfactory (from 0.5% to 1% each year), to a large extent thanks to a liberal work-based immigration regime. The unemployment rate has clearly declined since 2010. Yet even in Sweden, one can see that neither of the traditional political blocs (the left and the right) now seems able to form a majority in the Swedish Parliament. Instead, the Sweden Democrats (Sverigedemokraterna), which is partly heir to the Swedish neo-Nazi movement, has emerged as a party that at times competes with the two biggest traditional parties.

Of course, it is difficult to present watertight proof of the major role of supply-side policies in the success of populist policies. Yet this causal chain seems quite plausible. More stringent unemployment benefits, higher retirement ages, and, first and foremost, a steady increase in the migrant population are all rather plausible explanations for the current political instability.

European welfare states and their fragile finances

The British experience suggests that economic success is not enough to dissuade the electorate from seeking unrealistic and nativist political alternatives, and that immigration can be rejected even when it functions reasonably well. If the same holds for other European countries, this poses a policy dilemma for the financing of the welfare state. As explained above, it is hard to see how the European welfare undertakings can be adapted to meet the needs of an ageing society without a stringent supply-side policy package that includes a dose of work-based immigration. If such policies prove politically unsustainable, then there are few good policy alternatives. In the long run, the large and generous welfare undertakings typical of EU countries are not feasible if they are not underpinned by quite ambitious and robust employment policies. Such policies are possible and feasible in principle, but they do not leave much room for economic mismanagement and irresponsibility.

Thus, the ageing problem and the transition to a new demographic pattern do present a kind of litmus test for the feasibility of the European ‘social economies’. Many voters liked the welfare state and the public pension system in the 1960s and 1970s when both seemed to be easy to finance and neither demanded much sacrifice. As they now presuppose stringent supply-side policies, and even an acceptance of much more work-based immigration, their political feasibility is another matter. If this policy challenge is not adequately dealt with, future historians will have to conclude that the (currently) much-celebrated European welfare state was in fact only a temporary arrangement, made possible by the special and provisional demographic structure.

The jury is still out on this question. We have mentioned the countries with successful reform records, such as Sweden and Germany, but the travails of France and Italy—and even Finland, the Nordic outlier with an employment rate somewhere between those of the Mediterranean and the Nordic countries—show very clearly how difficult it is to build political support for effective labour market reforms that raise the employment rate.

Demography also constrains countercyclical fiscal policy

On top of the long-term policy dilemma outlined above, demography also constrains macroeconomic demand management. The state of European politics would be less strained if the macroeconomic management of the financial crisis had allowed more Keynesian reflation and less austerity. Many left-wing commentators have interpreted the macroeconomic policy during the crisis as an outright ‘neoliberal’ attempt to roll back the welfare state.

However, the sober truth is that the demographically constrained welfare state financing has also constrained ambitions for more Keynesian stimulus policies during the crisis. Again, there is a difference here vis-à-vis the decades after the Second World War. When the labour force was growing strongly, it was perfectly okay to assume that economic growth would take care of the deficits incurred during economic slumps. However, when the number of economically active workers and taxpayers stagnates or shrinks, bold Keynesian demand management during a crisis becomes a much riskier proposition. To introduce a policy of Keynesian stimulus and a deliberate increase of the deficit, one has to show that this will generate an economic growth path on which the increased public debt and public deficit will not place insurmountable pressures later on. In times of low labour force growth, this is often surprisingly difficult. Any responsible fiscal policy must therefore seek a compromise between fiscal consolidation and sustaining aggregate demand (see Kanada (2011) and Carnot (2014) for such analyses).

Thus, in an indirect way, the stringent demographic constraints have also constrained countercyclical fiscal policy during this crisis. Following through with such a policy is by no means impossible, but it requires a structural reform policy bold enough that today’s deficits can be met with strong employment growth and thereby a growing tax intake during the decades to come. For example, the Swedish administration of Fredrik Reinfeldt and Anders Borg, after taking office in 2006, immediately introduced an array of structural reforms in order to boost future employment growth (see Dölvik et al. (2015) for a description of the Swedish reforms). When the crisis struck in 2008, there was enough fiscal room to let the public balance deteriorate, and indeed Sweden ran a moderately expansive fiscal policy during the subsequent recession. Thus, there is no contradiction but instead a symbiosis between adequate supply-side policies and Keynesian demand management. Keynesian demand management is only feasible in fiscally hawkish countries. This basic truth is not appreciated in all political circles, unfortunately.

Conclusion: Are economically sustainable policies politically sustainable?

I have argued that the demographic transformation due to an ageing society is a major factor behind the current political instability in Europe. It has made supply-side policies and large-scale immigration necessary policy orientations, but this has, in turn, encouraged the very political protest that, in the form of populist nativism, is now challenging responsible economic policymaking. It has also limited the scope for expansive fiscal policy during the long recession since 2008. Responsible economic policies for fiscal sustainability have run into problems of political unsustainability.

There is no crystal ball that can reveal how these contradictions will play out in the decades to come. Fortunately, the European economies are now solidly on a path to recovery, with shrinking unemployment rates and fiscal deficits. The current challenge of populism might therefore run out of steam. Sooner or later it will also become apparent that the populist and nativist political parties do not actually have any solutions to the fundamental economic challenges of our time. They have not sought public office by wanting to dismantle the welfare states and if the European welfare states are to be sustained there is no alternative to responsible economic management—even if this is in the form of supply-side policies that at times may feel politically painful.