Flickr: Hugo--the Paris marathonAs everyone knows, fertility rates have been declining rapidly since early in the 20th century. In many countries, total fertility rates are far below replacement rates. At current speed, the once-great nations of Germany and Italy will be reduced to half in just about 50 years.

There are various explanations of what is behind such a rapid change. According to recent research in economics, the most important reason is surprising yet mundane: fertility decline is the result of misguided pension policies. Public pay-as-you-go pension systems have discouraged fertility by replacing the traditional family system and penalising those who raise more children (1).

There are at least two reasons why public pension systems should affect fertility rates. The first reason is that they replace the traditional family as a source of old-age security. This is the "substitution effect" of compulsory pensions.

Pension systems come in various sizes and shapes, but the most common type of governmental system is the pay-as-you-go (PAYGO) arrangement. It means that current workers pay contributions from their salaries, and this money is distributed among current retirees. In other words, pensions are financed by way of intergenerational transfers. This system was invented in Bismarck's Germany, from which it spread to various other countries in the first half of the 20th century.

When there is no compulsory PAYGO pension system, people have children not just for the fun of it, but also because children provide security in old age. The old-age security motive for fertility was clear in the developed world before the 20th century, and it continues to be so in less developed countries (LDCs) today.

The traditional family is actually a kind of private PAYGO scheme. Parents procreate, nurture and educate their children, and in return children look after their elderly parents once they can no longer provide for themselves. This is the common pattern across LDCs even in times of urbanisation and when children travel abroad to work or study.

The family arrangement has its limits, of course. For one thing, it is prone to localised shocks such as illness, disability or unemployment. This is why in traditional societies, the norm is the extended family, not the nuclear family. The extended family is a risk-pooling mechanism.

Children: blessing or burden?

The effect of pensions is not limited to the substitution effect. There is a more damaging aspect, which is that public PAYGO schemes make children an economic burden instead of a blessing. This is the "free-riding effect" of public pensions.

From the point of view of fertility, a compulsory pension scheme externalises the value of children (or, to be more precise, a portion of their productivity). Children can no longer support their parents in old age, because a chunk of their salary is forcefully taken away from them and distributed to the entire population of retirees. That chunk is growing systematically, because governmental pension schemes are heading towards insolvency due to, among other things, low fertility rates.

Now, such socialised generosity sounds nice. Unfortunately, it wreaks havoc on social structures and private incentives. Individual parents no longer retain the economic benefit of having children, but they must still bear the bulk of the costs in terms of time and money spent. Everyone receives the same pension rights regardless of how many children they had, if any. Many are tempted to take a free-ride on the children of others.

In other words, the welfare state becomes a "forced family" that replaces the traditional family as a provider of social insurance. It is not only an alternative to the traditional family, but an option one is not allowed to refuse. Undoubtedly it provides some benefits, but it lacks the sense of common goals and reciprocity which is essential to real families. Because the participants in the welfare state system do not know each other and have no regular dealings with each other, there is a strong temptation to seek to maximise private benefits. Hence the free-riding problem.

Of course, parents do not always bear the total cost of raising children. For example, child-related benefits counter the negative effect of pensions somewhat. This is seen in statistics too: Scandinavian countries, which have large child-related benefits, have somewhat higher birth rates than the rest of Europe. But even their total fertility rates of around 1.7 give little reason for applause.

In contrast, children are still welcomed as a blessing in LDCs, even though real incomes in these countries can be extremely low. On the face of it, this is mysterious, but the old-age security factor explains it. Children are indeed a blessing, not just socially and spiritually, but also economically. It takes time and money to raise them, but soon they start to contribute for themselves and the good of all. The longer they live, the more they can do for their local community and their family.

Lessons from history

The effect of pension policies on fertility rates is evident in practically all data, both past and present. The radical fertility transition started in the 1930s and 1940s, exactly when public pension schemes began to spread and grow in size. The change was larger in Europe than in the US, and it also started earlier there, which matches perfectly the fact that public PAYGO pensions were first created in Europe and that they are much bigger in size.

The role of families in providing old-age security was, as a matter of fact, commonplace in 19th century Europe. When Bismarck set up the first public pension scheme in the world, his aim was precisely to create a substitute for the family. Whatever his motives for such a move, he succeeded very well indeed. Before Bismarck, Germany had one of the highest fertility rates in all of Europe. Now, its total fertility rate is below 1.4.

The public pensions factor may also explain the mystery of the low fertility rates in Mediterranean countries. Spain and Italy are countries with a strongly Catholic cultural inheritance and are famed for their family values. Yet their total fertility rates are around 1.3, among the lowest in Europe. This is rather surprising. However, when one looks at their generous pension systems, and the relative lack of child-related benefits to counter that, it suddenly makes sense.

The same is true of post-Communist countries, including Poland, which is probably the most Catholic country in Europe. But currently the Polish fertility rate is a staggeringly low 1.25. Other countries such as the Baltic states and Russia show similar figures. This is perfectly consistent with the fact that their Communist regimes despised the family and also set up very generous pension rights.

Reforming pensions for a higher birthrate

This is not to say that economics explains everything. There are various other factors that influence birth rates and the broader value-orientation of societies. One thing is the diffusion of contraceptive technologies and the legalisation — and, very importantly, public financing — of the killing of children yet to be born. No one is forcing modern men and women to adopt these means, but their availability at a low cost makes a difference.

For the same reason, reforming pensions is not just a matter of economic efficiency. It is also a matter of culture, values and the future of societies. Culture is a complex result of purposeful human behaviour and interaction. Economic incentives influence human behaviour and culture too. Bad economics breeds bad culture.

Moreover, as things are going now, the once-great nations of Germany and Italy will be reduced to a half in size in little more than 50 years. Their pension systems can perhaps be kept running by allowing mass immigration from Middle East and North Africa, but after that not much would be left of their cultures. Mass immigration is a poor solution to the pensions problem for other reasons too, because it tends to create issues even more difficult to resolve.

An easier solution may be available. Pension rights could be linked to fertility choices in such a way that those who raise more children are compensated for it. Thus having children would be given its aspect of "investment" in old-age security. Those who have few or no children would have to save more privately. This would be fairer to all participants, and the system would be more sustainable in the longer term.

A more radical solution would be to cut down the scale of the public PAYGO system. This would be a bigger change, but ultimately it would be simpler. There would be no need to figure out the complex details of a pension system, which always has anomalies and loopholes. Instead, those who have more children would automatically receive better old-age security, just as in the past. Others, who cannot or do not wish to have kids, could invest the difference they save in a larger private pension.

Whatever option is chosen, it will the result of free human choices. For the ultimate driving force of human history is neither technology nor economics, but culture. At times it goes below the surface and seems to have lost its relevance, only to rise again to show its transforming power. As Viktor Frankl has forcefully shown, even in times of great pressure, confrontation and martyrdom, men retain the core inner power called freedom.

Oskari Juurikkala is a research fellow at the Institute of Economic Affairs, UK, and legal counsel of Magnus Minerals, Finland. Trained as a lawyer and an economist, his work has appeared in Economic Affairs, Quarterly Journal of Austrian Economics, Journal of Markets and Morality and Religion and Liberty. Contact him at oskari.juurikkala@gmail.com.

Notes

(1) See for example Isaac Ehrlich and Jinyoung Kim, "Social Security and Demographic Trends: Theory and Evidence from the International Experience," Review of Economic Dynamics (2007, forthcoming); Michele Boldrin, Mariacristina De Nardi and Larry E. Jones, "Fertility and Social Security," National Bureau of Economic Research (NBER) Working Paper No. 11146 (2005).