What if, in five years time, our country could not afford to pay the current way of functioning of the state?
Compared to the other European countries, the current situation of Luxembourg’s public finances is not that bad, as the 2012 budget foresees a deficit below 1% of GDP and public debt does not reach 20% of GDP, thereby respecting the Maastricht criteria.
In parallel, the international environment and the global economic governance are fundamentally changing, in exogenous fashion, without us being able to escape from it. Indeed, the creation of genuine economic governance entails more harmonization of economic policies of Member States and limits the margin for maneuver of national governments. The efforts towards the convergence of economic policies also create an increased pressure to reach a harmonization of tax policies and it is difficult for an individual Member State to resist that pressure. Whereas we managed to profit from the advantages of globalization, we are fully aware of our vulnerability to shocks in the increasingly globalised world economy. The increasingly aggressive attitude of third countries towards European financial centers, like Switzerland and Luxembourg, should set alarm bells ringing. All these observations show the world has changed and we must adapt to that reality.
Whereas the well-being and the affluence of Luxembourg essentially took source by basing itself on former paradigms, the country now has to face new political and economic orders arising from the new world economic context.
Necessity for reaction
Failing to be able to change the new global context, in which we operate, we are forced to comply with it and to adapt, otherwise our next generations will be penalized by an environment which is less and less accommodating for Luxembourg. The world around us is changing. If we do not adapt, the wake-up call will be brutal.
The economic model which has created our wealth is indeed based to a large extent on niche policies resulting from strategic decisions skillfully taken by successive Luxembourg governments. The structural or systemic changes of the environment imply that this policy be constantly adapted and refocused. Indeed, our economy of small size is structurally fragile by the absence of an internal market and by its high exposure to international uncertainties. The risks that such an economy run go beyond economic phenomena: the dangers are essentially structural and more crucial than the ones our large neighboring countries are confronted with.
Such an adaptation of our economic model will take time and will be based on a long-term vision that goes beyond the electoral terms and that takes account of the next generations in the debate. If we do not react, we will jeopardize the balance of public finances and endanger the well-being of citizens, in particular of our next generations.
Exacerbated consequences
The consequences to be borne by the next generations are exacerbated in Luxembourg because of the following factors:
1. Long-term commitments
If the pension system is based on the inter-generational contract, it must be sustainable in order to be honored by the next generations. If we leave everything unchanged, the burden of its financing will exceed a tolerance level and will become unbearable for next generations. In the case of Luxembourg, long-term stability of pension regimes can only be guaranteed through a strongly positive evolution of economic and demographic growth.
However, a scientific study already now envisages the extent of financing our next generations will have to face, without even considering the hypothesis of the occurrence of financial risks to which Luxembourg is confronted as a result of the changing global context.
If indeed Luxembourg could not sustain its exceptional standard of living compared to its neighbouring countries, the financing of commitments in pensions as they exist now would evidently entail completely unmanageable costs in the future.
2. The downward rigidity of expenditures and the vulnerability of revenues
The downward rigidity of a majority of public expenditures prevents us from readjusting the cost of functioning of the state in the occurrence of a possible fall in revenues. This lack of flexibility is a problem. A non-adjustment of expenditure to a lower level of revenue will bring about budgetary deficits that will be all the more important as the non-adjustment is greater.
However, a negative evolution of revenues is not unrealistic and has to be envisaged; the change in global context as highlighted above is all the more detrimental to Luxembourg as the country’s revenues largely depend on the financial sector, whose activity is steered from abroad in response to considerations that are independent from the fate of Luxembourg. Indeed, the decisions to relocate are not taken in Luxembourg or by Luxembourg nationals.
Such a relocation movement of financial activities would have the detrimental effect to take away from the State all or part of the tax base to the extent that, even if it wished, the State could not make up for the loss in tax revenues through tax increases, as the substance to be taxed has already left the country.
Our well-being under threat
Luxembourg has taken a loan of a billion Euros. From an economic point of view, a loan makes sense if the return on invest is higher than its cost of financing. In other words, the rate of profitability of investments must be higher than the interest rate. Regarding the financing of an economy, this equilibrium is translated into the rule that GDP growth rate should ideally be above the interest rate on public debt, even though other economic elements can be taken into account.
To respect this basic principle of financial orthodoxy, the loan has to be solely allocated to the financing of new investments, thereby excluding the use of a loan to cover treasury needs.
Furthermore, the rate differential will be all the more difficult to sustain as the positive gap between both rates risks to simultaneously deteriorate on both sides. Low or negative GDP growth risks degrading the solvency which in turn can bring about an increase in interest rates for future borrowing. The gap between the cost of borrowing and GDP growth widens on both sides as a result of the same phenomenon. The equilibrium of sound financial management is doubly impeded.
Our long-term well-being and our future will not necessarily be a repetition of the past. Prudent management dictates that Luxembourg ensures to equilibrate its public finances, especially on the long run. Public expenditures must be managed and controlled.
This problem might not be perceived by everyone and might not be tangible today, but vast structural reactions are needed to prevent Luxembourg from entering further into a spiral of deficits and debt. We must be ready to envisage, study, initiate and accept the changes at every level in order to allow for equal opportunities for the next generations compared to what their forefathers have known.