Get ready for the great demographic reversal
Ultra-low inflation and interest rates could end as a generation of retirees begins to spend its savings
Last week I argued that as and when aggregate demand recovers after the coronavirus crisis, central banks might adopt a laxer attitude towards inflation. But will demand ever recover to the point where inflationary pressures revive?
It is now widely believed that depressed aggregate demand, accompanied by ultra-low inflation and near-zero interest rates, is the new normal. This state of affairs predates Covid. After all, in the years after the financial crisis of 2007/09, and originating even before then, the world was characterised by ultra-low economic growth and low inflation – despite extremely stimulatory monetary policy.
Some distinguished economists suggested that we were in an era of secular stagnation. What’s more, they said, there was no obvious end in sight.
There came to be pretty general agreement that the world was suffering from an excess of desired savings in relation to desired investment – the so-called savings glut.
But there was disagreement about the main explanation. Some economists emphasised increased inequality. Some stressed global imbalances. Others pointed to depressed corporate investment and blamed the structure of executive incentives.
It is tempting to conclude that each of these has something to contribute to an explanation of what has happened, with the exact mixture differing between different parts of the world. But it is intellectually unsatisfactory to rely on a ragbag of explanations for a major global phenomenon.
A new book has just appeared which proposes a single major development as an explanation of what has happened – The Great Demographic Reversal, by Charles Goodhart and Manoj Pradhan.
The authors do not negate the candidate explanations referred to above, but incorporate most of them within an overarching explanation, including a factor that has been unduly neglected by most economists, namely demographics.
Their explanation begins with the integration into the global trading system of China and other emerging markets. This effectively amounted to the addition of over one billion workers and not much capital to the world economy.
The result, as you would expect, was a depression of real wages in the developed world and higher profits, leading to increased inequality, downward pressure on inflation and, given the savings propensities of these countries, deficient aggregate demand at the global level. This had to be counteracted by ultra-loose monetary policy.
So much, so conventional. Where the authors bring something new to the table is their stress on demographic factors within the developed world.
Over the years 1980 to 2010, in most developed countries, the working age population was rising quite significantly, reflecting the earlier baby boom. Meanwhile, the dependency ratio, that is the ratio of both young and old non-workers to workers, declined as the birth rate fell and the number of retirees hadn’t yet risen. The participation rate in the workforce was also increasing, driven partly by the increased employment of women.
This internal demographic factor had effects in exactly the same direction as the China factor. So the world economy experienced the largest ever positive labour shock.
Goodhart and Pradhan say that over the years from 1991 to 2018, the effective labour force for the world’s trading system more than doubled.
Because of the attitude of China and other emerging market countries to running current account surpluses, their rise boosted world savings and depressed world demand.
The internal demographic factor in the West did the same because of the typical pattern of saving and spending across a person’s lifetime.
The peak saving years are the middle ones. In retirement, by contrast, people typically spend in excess of their current income and finance this by running down their accumulated assets.
For the last 40 years, with regard to the growth of the labour force, the developed countries of the world have been in a so-called demographic sweetspot. But as far as the generation of aggregate demand is concerned, this was in fact a demographic sourspot. The age distribution of the population favoured saving over spending.
What of the future? Nowadays, very few people think that we will ever return to the conditions that we once thought of as normal, including decent increases in real incomes and decent levels of real interest rates.
But those of you with an interest in history will know that, since the Industrial Revolution at least, we have been through several different economic eras, each one sharply different from the others. And in each one people have typically believed that the current conditions, no matter how different from what went before, were bound to continue ad infinitum.
Goodhart and Pradhan’s analysis is striking not only for the explanation of past and current trends but also for what it says about the future. They argue we are now at a demographic turning point. In both East and West, populations are ageing rapidly. Many countries, including Japan, Germany and China, are going to experience dramatic drops in the working age population, accompanied by major dissaving by the old and retired. Only continued rapid population growth in Africa and India may stand in the way of a significant shift in global economic conditions.
Global ageing is going to lead to a reversal of many of the things that have come to be regarded as the new normal. Once the Covid crisis is over, during the next few decades there will be an intensifying shortage of labour that will drive up real wages and reduce inequality.
Meanwhile, as this is accompanied by a revival of aggregate demand, there will be upward pressure on inflation and interest rates.
I realise that this vision seems a long way from current reality. And, in my view, you certainly should not anticipate anything like it in the immediate future. Indeed, quite the opposite.
But if you are going to peer into the further future then you must be prepared to see something markedly different from current reality. Goodhart and Pradhan meet this challenge. I suspect that they are on to something.
The world’s ageing population points to a shortage of labour in the coming decades