background note growth rates, reforms and risk of overheating 1 2 october 2017 economic growth is a subject of frequent debate. this paper elaborates on why future growth in the gross domestic product, gdp, can be expected to be lower than that seen in recent decades. the short - term risks of overheating are then discussed, and whether structural reforms could potentially counter them. finally, there is a box on the interpretation of growth rates. what is a realistic growth rate in the long run? potential output in a society, i. e. its economic capacity, is determined by the amount of work performed, the size of the capital stock available and how " smartly " people work ( productivity ). increased economic activity creates a basis for higher demand, but demand for goods and services can also be covered via imports. the underlying, or structural, growth in economic capacity is determined by underlying developments in productivity and hours worked, but in the short term growth may be higher or lower than its structural level, depending on demand. major imbalances between demand and economic capacity lead to inflation or deflation. so a good balance in the real economy is essential to the value of money and financial assets and liabilities. there are several reasons why future economic growth rates, and hence expansion of economic capacity, are likely to be lower than in the 20th century. the most obvious explanation is the demographic shift from a growing to a stagnant population with a higher percentage of pensioners. moreover, the historical increase in the participation rate of women cannot be repeated. in addition, the last 10 - 20 years have seen a relative dampening of productivity growth rates. this is partly due to a shift in economic structures, away from agriculture and industry towards services, with less room for technological advances to enhance efficiency. other aspects of the dampening are not so easy to explain. it is not a uniquely danish phenomenon, but applies to nearly all of the western world. the oecd's long - run projections operate with annual gdp growth rates of around 1. 5 per cent in western countries over the next 50 years. that is lower than in the previous 50 years. one question is whether further structural reforms could change this outlook. in general, there are good reasons to implement structural reforms as they can help to increase the capacity of the economy. successful structural reforms mean that the economic capacity will be higher than it this paper is background material for a presentation at the 3s board seminar on 2 october 2017

perhaps decline even further. this finding leads to a couple of questions. why is r * declining? and what are the implications? as to the " why ", several global structural factors are driving the decline. one factor is lower structural economic growth. in many advanced economies, we have to get used to structurally lower growth going forward, due to modest productivity growth. another factor relates to the global savings glut. when desired saving exceeds desired investment, the interest rate falls to balance the two. if we take a closer look at who is saving, we see that a large share of global savings is concentrated among the richest households in the u. s., china, and japan. in countries like china, households have increased their demand for financial assets. understandably, the incentive to self - insure has increased, as the chinese have become wealthier and expect to live longer. this incentive is further strengthened by inadequate access to social safety nets. but demographic changes are also boosting savings in european households, as rising life expectancy leads to higher savings for retirement. this means that ageing populations not only challenge pay - as - you - go pension systems – with fewer workers paying for the retirement of larger side 3 af 7 generations. they also present challenges for funded systems by lowering structural interest rates and thus, returns on savings. this leads to my second question – what are the implications of a lower r *? a number of effects are worth considering. the effectiveness of monetary policy to respond to an economic contraction may be hampered. real rates will have to be lower than r * to stimulate the economy. another key implication is that the structural factors holding down r * are neither expected to be short - lived nor to reverse anytime soon. therefore, lower rates are probably here to stay for even longer than justified by the business cycle. low interest rates and low growth present challenges for pensions continued easing of monetary policy and lower structural interest rates will intensify the challenges currently facing institutional investors and the pension system in particular. these challenges are further compounded by the gloomy outlook for growth, as well as demographic developments. for defined contribution schemes, current contribution levels are likely to produce disappointing and inadequate results, all else equal. similarly, the costs of defined benefit guarantees will increase. the lower the rate of interest, the higher the present value of liabilities. this weakens long - term solvency and exacerbates challenges of underfunding. the funding gap is widening and a recent