A Glimpse of the Future

Where have the children gone...?

Former East Germany already served once as a natural laboratory. Right after World War II, it was forcefully isolated from West Germany by a well-nigh impregnable iron curtain and subjected to the full joys of a centrally planned economy. Its sibling to the west, in contrast, embraced the capitalist, free-market version. A bit more than forty years later, the separating curtain came down and both systems could be compared side by side. Despite arguably having shown the best performance among the former Eastern Bloc countries, East Germany was no match for the economic prowess attained by then by West Germany.

Now, the very fall of that iron curtain has turned the former East Germany again into a natural-experiment laboratory. Fifteen years after German unification, it has become a forerunner for the looming demographic debacle that awaits many countries in the near future.

One side-effect of unification was a huge drop in the east's birth rate, which, at 0.77 children per woman, is the lowest ever observed in any single country. This compouds the negative effects of the significant outmigration towards western Germany that occurred right after unification, when nearly 10 percent of the former East Germans left. (By now, contrary to conventional wisdom, low fertility derived from too many old people and too few young ones is the driving force behind the declining population, not emigration.) This has transformed the former east Germany into a laboratory where all changes industrialised countries will face sooner or later can be observed occurring at high speed—and with extreme consequences. The picture is grim. What this means for the pension and health-care markets has been studied. What is less clear is what it will mean for the local labour market.

Until now, that is. Marcel Thum, a professor of economics at the Dresden University of Technology and head of the Ifo Institute’s Dresden Branch, and his colleagues Beate Henschel and Carsten Pohl have just released a paper that examines the impact of demographic change on labour markets, taking eastern Germany as their case study.

Eastern Germany’s population, they point out, is expected to decline by 7.3 percent from 2005 until 2020, but its working-age population will do even worse, plunging by 16.5 percent. How will the labour market react to the onset of such a demographic shift?

On the one hand, given the east’s persistently high unemployment rate, stuck at around 20 percent, you would expect the shrinking labour force to go some ways towards reducing this rate. But on the other hand, skilled labour will also become scarcer, at a time when skills are at a premium in industrialised economies, putting a strain on skill-intensive industries. Furthermore, local demand for non-traded goods and services will also decrease, due to the shrinkage of the population, leading to a reduction in the demand for labour. The net effect of demographic change on the labour market is, thus, far from obvious.

In order to find out how the labour market might evolve, the researchers set up a stylised model of a regional labour market that is exposed to demographic change. They constructed their model as a computable general equilibrium model with rationing in the labour market and calibrated it by capturing the current situation of the eastern German labour market.

Using data from two data sets from the Federal Statistical office they projected the evolution of the workforce in eastern Germany, including the skill composition of the population by age and gender, and the rate of labour participation. Their analysis shows that there will be a reduction in the number of low-skilled up to 2020 (-15.4 percent), while the medium-skilled will shrink by marginally less (-15.1 percent) and the highly-skilled by -11.6 percent.

The distinction the authors make between tradable and non-tradable sectors in crucial, since the majority of the eastern German labour force is employed in the non-tradable sector. The decline in population will bring about lower demand for non-tradable goods, which will slightly reduce demand for workers in eastern Germany. The tradable sector will not fully compensate this decrease, so that the total labour demand in eastern Germany will likely decrease from 6.7 million at present to 6.1 million in 2020. Since labour supply will decline more strongly than labour demand, the total number of unemployed could decrease.

Applying these and other data to their calibrated model, the authors found that there could be a bottleneck of highly-skilled labour after 2013, which could lead to a significant increase in the wages for this labour group. This, in turn, will lead to rising income inequalitities.

While the authors warn that the results of their simulation should be interpreted with caution, as they left out several important aspects (such as the effects of an ageing society on productivity, shifts between sectors and the like), they do enumerate some premilinary policy implications. Among these, those aiming at increasing the supply of highly-skilled labour should be top of any list, as they could help offset the relative shortage of this kind of labour that is to be expected in regions affected by a dramatic decline in its working age population.

Education and immigration policy, in turn, as well as changes in early retirement policies, are obvious examples of how to prepare for the looming demographic shift. With a forerunner showing so clearly what to expect, policy-makers in countries faced with a Grey New World in their near future now at least have some pointers on how to cope. Given that many of these policies need time to come to fruition, the time to act is now.

Beate Henschel, Carsten Pohl, Marcel Thum: Demographic Change and Regional Labour Markets: The Case of Eastern Germany, CESifo Working Paper No. 2315

• Other CESifo Working Papers dealing with demography
• Other CESifo Working Papers by Marcel Thum
• CESifo Working Papers published in the past three months