Chile’s lessons for European welfare states

By
Pieter Cleppe
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In recent years, the debate on the so-called “demographic collapse” of Europe has heated up. At the moment, birth rates in the EU are below the replacement rate of 2.1 children per woman in all 27 member countries. That is despite the fact that according to surveys, both men and women in Europe wish they had more children than they actually do.

Many different opinions exist on the subject, but in any case, in the context of a welfare that, the core concern here is that there will not be enough young, productive people left to pay for the pensions and the health care of elder people. In particular, this is a problem for those European countries with a “pay-as-you-go” pension system. This is a system whereby people pay into a government fund dedicated to providing them a pension, but whereby these resources are not saved but instead directly used to pay those pensions to those that have already reached the minimum pension age.

Most European countries have a mixed system, whereby the government offers a basic pension which is being supplemented with private pension arrangements, that often enjoy preferential tax treatment. In countries with a high percentage of such private pension arrangements, investing in it is mandatory, to a degree.

Europe’s “unfunded liabilities”   

Those enjoying horror movies ought to have a look at the “unfunded liabilities” of European welfare states, which basically amounts to the real public debt of these already highly indebted governments. According to estimates, unfunded pension entitlements in major European countries are between 300% and 500% of GDP. In combination with collapsing demographics, one can say a perfect storm is brewing.

The Netherlands, Sweden, Denmark and Switzerland seem to be doing quite a lot better than the rest of Europe here. The key reason is the relatively high percentage of private pension entitlements that people enjoy there.

Then, also these systems are not without risks. In particular during the years where interest rates were nominally at zero or negative, Dutch pensioners witnessed their pension being cut. This is because of regulations forcing pension funds to be prudent. When interest rates are so low that these pension funds are no longer able to offer the legally guaranteed minimum percentages pensioners are entitled to, they are forced to reduce the pension payments to these people. To be clear, the ultimate culprit here has been the European Central Bank’s (ECB), which helped drive interest rates into negative territory in order to keep the Eurozone’s many highly indebted governments and thereby also the Eurozone itself afloat.

However, even after the cuts, Dutch workers would still receive more generous pensions than employees in other rich countries, according to OECD data.

Chile as a model

The pension system whereby people largely save for their own pension instead of hoping that there will be a large base of young taxpayers in the future has been named the “capitalisation” system. Here, Chile, of all places, is a role model.

The system was recommended by classical liberal economist Milton Friedman, who won the Nobel prize for his work. As a result, Chile opted for such a private pension system whereby benefits would be connected to the contributions paid by people into the pension system. The cash paid by workers was moved into an account that is owned by them.

The system was a great success, even if there was a transition cost of around 3 percent of GDP. This was so high because the Chilean state could no longer use pension contributions to pay for the pensions of those that already had reached pension age. As a result of the reform, introduced in 1981, the country’s savings rate went up to 25 percent and its annual growth rate doubled, between the 1970s and the 1990s. Today, Chilean private pension funds manage around $212bn, equivalent to 75% of Chile’s annual GDP. The funds have managed to offer a 8% return per year since the 1980s.

It must be noted that this pension reform was implementing during a deep economic crisis, resulting from policies introduced by Marxist President Salvador Allende, who had been elected in 1970. During this period, GDP per capita in the country recovered, so it is clear the measure helped with recovery. It was Chilean dictator Augusto Pinochet, who decide to introduce these reforms, but despite this rather questionable connotation, Chile has stood as a model for pension reform throughout the Western world, for example in the Mercer CFA Institute Global Pension Index.

How the mighty have fallen

It must be added that also in Chile’s case, the system was strongly regulated, and far from completely free. Workers were required to pay at least 10 percent of their salary into their pension account, and were free to contribute up to 20 percent. Annual returns were not taxed, but withdrawing the money when the pension age was reached was taxed – albeit at a lower rate than when one withdraws the money before the pension age was reached.

Sadly, over the last ten years, the high rate of economic freedom which helped Chile to recover economically dropped, after also the pension system was turned into a mixed system, in 2008. Chile’s pension system, significantly dropped in Mercer ‘s pension index as a result, even if it remains among the best in the world. A sign of the times was the election of Gabriel Boric, a militant leftist, to President of Chile in 2021.

Meanwhile Boric has already fallen out of favour, and Chile’s international image has been dented by a high-profile corruption case. This Summer, Luis Hermosilla, a criminal lawyer with close ties to prominent business leaders and senior politicians across Chile’s political spectrum, has been indicted on bribery, money laundering and tax fraud charges.

Chile ranked as the region’s second-least corrupt country, behind Uruguay, by Transparency International in its 2023 corruption perceptions index, but according to analysts, the growing scandal risks damaging Chile’s image. “The case suggests Chile’s best-connected people are improperly trafficking influences,” Patricio Navia, a Chilean political analyst and professor at New York University, told the Financial Times.

Prominently, the case has led to the resignation of the head of Chile’s investigative police force, Sergio Muñoz, after he was accused by prosecutors of having shared confidential information with Hermosilla on running investigations. One of these investigations is connected to the granting of gambling licences to the ‘Enjoy’ chain of casinos and resorts. Moneda Patria Investments, a company with political connections to the right of the spectrum, would apparently stand to benefit from these licenses. A judicial investigation looked into the matter, considering whether legislation introduced by the right-leaning administration at the time benefited Moneda and whether it even prevented the company to go bankrupt. It was dismissed by a judge in 2023.

In another scandal, Chile’s interior ministry Undersecretary Manuel Monsalve had to resign, after being accused of rape in a case involving a woman civil servant. The string of corruption scandals is seen as having contributed to heavy losses suffered by Chilean President Gabriel Boricin local elections that are seen as a litmus test for the 2025 presidential election. But apart from the fate of Boric, it is all deeply concerning for Chile’s reputation as Latin America’s shining example in good governance, after market-oriented reforms had managed to reduce the number of  Chileans living below the poverty line from more than one half the population to less than one-tenth.

Lessons for Europe

What Chile shows is how success is never guaranteed and how even profound economic problems can be solved, provided the right policies are implemented. Europe’s welfare states are at risk, the European Central Bank’s president Christine Lagarde has just warned.

She stated that without bold economic policies, European countries “will not be able to generate the wealth we will need to meet our rising spending needs to ensure our security, combat climate change and protect the environment”. According to her, Europe may be  facing “a future of lower tax revenues and higher debt ratios” which would result in “fewer resources for social spending”.

One option is for Europe to opt for Lagarde’s printing press, financing welfare spending through depreciation of savings. This is the route taken by banana republics. Another is to look at how countries that were in much more dire straits than Europe have handled such challenges. Chile may be worth a look for Europe, but it recent slide equally demonstrates how economic success should never be taken for granted.  

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