If Demographics is the Problem, What's the Solution


In the comments column of Brad Delong's blog Amit Dubey asks the following:

So if demographics is the problem, what's the solution? And how should other countries handle it e.g. a big tax hike now in order to fund government consumption when demographic inflection hits? I don't think "immigration" is a good answer, because then what do India and China do a couple decades down the road? (and, perhaps more optimisitcally, what will Nigeria and Congo do a couple decades after that?)
Source: Semi Daily Journal
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My attempts to answer this quite important and legitimate question have given rise to the following thoughts.

Firstly 'What's the solution'? Apart from stating there is no insta-pundit solution on this one, there are obviously things we can do. Reduce our deficits in the good times for one. Carry out pension reforms and encourage private saving for two. Increase the retirement age for three. Individually have more children, for four. And most important of all change our attitudes to immigration.

Of course, none of these 'solve' the problem. But they may make things better rather than worse. If Britain scores rather favourably on the ageing vulnerability index, for example, it is because it has made important progress on pension reform, immigrant acceptance and multicultural identity when compared with its European neighbours. Is this unequivocally good? No. The pension reform comes at a price of increased poverty among old people. Is there much alternative? I don't think so.

The point about India and China is a good one: one day the planet will run out of immigrants. But what may be only a stop-gap solution does buy time, and that could be important as this is what we need to feel our way forward.

Secondly: "if demographics is the problem"

Interestingly more and more people seem to be waking up to the fact that it might be at least part of the situation. Last month it was Alan Greenspan, now it is the deficit 'hawks' Volcker and company:

"Looming at the end of the decade is a demographic transformation that threatens to swamp the budget and the economy with unfunded benefit promises, like Social Security and Medicare, of roughly $25 trillion in present value. Our children and grandchildren already face unthinkable payroll tax burdens that could go as high as 33 percent to pay for these promised benefits. It is neither fiscally nor morally responsible to give ourselves tax cuts and leave future generations with an even higher tax burden."

Remember: the 'pension reform' which is most the likely outcome, even in the US, is tantamount to a massive Enron-style default on previously contracted obligations, only this time the defaulting party is the national exchequer. This is bound to have an impact on saving, consumption and the output gap.

What's the solution. This is a fair question, and the honest answer is that I don't know.

The best answer I can come up with right now is that since an economy is a form of complex adaptive system, then there will be some automatic stabilisers. Maybe our expectations form part of the picture. Maybe we are assuming as inbuilt growth patterns which have only characterised the last two hundred years.

Taking three parameters - technology, population and per-capita incomes - as key variables, we can see that for most of human history prior to the industrial revolution (outliers like the Greek and Roman empires being exceptions, and for interesting reasons) better technology meant more people and near stagnant living standards. This was Malthus' argument. Then came the industrial revolution, and both population and living standards increased rapidly with technological change. Now we have the information age, and technological change accelerates (possibly following a power law distribution?) population begins to decline, and we don't know what will happen to per capita incomes. Period: we don't know.

The point about Nigeria and Congo is also interesting. A demographer called Keyfitz once developed something called the population momentum equation. This is much more imporatnt than the name sounds, as it enables forward looking calculations on demography. Have you ever asked why the demographic problem has hit Japan first? Well Keyfitz goes a long way towards the answer. It's all about how quickly you make the first part of the demographic transition (the part which goes from 3-4 children per woman to below 2.1). Well if this occurs in less than one generation (simplifying greatly), then the population effectively becomes rapidly de-structured and enters a downward spiral. That is why Japan is first, and other countries like Italy, Spain , North Korea, Taiwan etc (who begin and complete their transitions later, and more rapidly than EU 'core' countries like the UK and Germany, and who also historically have less immigration) follow in quick succession. This could lead us to expect that in India, China and Brazil the situation could be still more dramatic (since latest word from the UN is that the transition is accelerating in these countries), and so on till we reach Nigeria and the Congo. That is if HIV-AIDS doesn't get there first. Remember, things get faster, faster.

Lastly, in terms of analysis, and especially in terms of more conventional economic analysis, this process can be approached from both a macro and a micro angle. With the proviso that it's only when you come to lay the macro-horizon on its micro-foundations that, I feel, the extent of the problem becomes clear.

On the macro side standard growth theory can serve as well as any other starting point.

Solow suggested that Y= A f(K,L)

Well I would suggest(following Mokyr) that this characterises fairly well industrial society with high proportions of fixed capital , but that in the information age (the age of human capital, remember the adage: a firms most important asset are its workers), a better formulation might be:

Y = A f(K, L1, L2,........Ln).

If the function looks something like this, then obviously if the sum of the growth in value of each of the various components of human capital exceeds the reduction in quantity, you can still have growing GDP. This problem is extremely tricky to model, as Solow notices in his critique of endogenous growth theory. It is easy to build a model with exploding, knowledge driven growth, it is far more difficult to envisage this occuring in practice. In part this is for reasons associated with our understanding (or lack of understanding) of Total Factor Productivity (or TFP). At present my understanding of this is still mirky, and it is better described as work in progress.

For the other part the actual values of the various human capital elements depend on the demand side equations, and it is here that consumption enters. I find Angus Deaton's notions of liquidity constraints enormously suggestive. Basically the collective constraint will be related to perceived rates of growth going forward, likelihoods of government debt (or pension) default, and the respective age structures and dependency ratios of the population. The nub of the matter seems to me to be how rapidly the younger age groups in society are willing to advance consumption, and, given their relative numberic weakness, at what rate of indebtedness.

This is as far as I have gone to date. Anyone willing and able to take this type of problem forward to a succesful conclusion deserves a Nobel in my book. Any good suggestions or lines of investigation, please contact me.

'D' Day Preparations Down at the Fed

So just in case 'it isn't just the war, stupid', the Fed does seem to be moving ahead vigourously with battle plan 'B'. (I sure hope George Bush finds the time in his crowded agenda to let himself be briefed on this one). Obviously all the talk of war has put everyone in a macho mood. After Krugman's allusions to the 'Baghdad is for boys, the real men want to go to Teheran' doctrine, this week we have the Fed's McTeer say that 'it would be kind of fun to fight deflation'. He must have a pretty boring life if he thinks this is going to be fun! Mind you, after reading that George Bush has nothing better to do with his Saturday afternoons than nibble pretzel on the sofa while watching football nothing really surprises me any more. (Presumeably this is the couch potatoe minus the six-pack, which must make it even more boring).

More to the point is McTeer's 'as long as you're pumping out money at a faster rate than the demand for money is rising you're going to stimulate spending', since its the 'as long as' bit that's important: the Japanese have been finding that the demand for money is quite capable of running neck-and-neck with its rising supply as the store of value component takes over the heavy lifting from the means of exchange one, in a world where the value of everything else is falling against money, and the speed of circulation is slowing down. (Come to think of it: maybe this is the real force of the critique that economic theory is still too dominated by the world of Newtonian mechanics, maybe to many people have never got their heads round the implications of special relativity theory. The salient point here, I think, is that you can run round and round very fast indeed, and still come back to a place where things have barely moved. Still since all the 'real men in Teheran' BS has gone to my head, I have to confess that I find the Wolfram vision of a set of space-time coordinates floating on a platform of information much more sexy).

Getting back to reality: I think the point about the anti-deflation package looking good on paper since it is not yet tested is an important one. My preoccupation is that, like many others things which look good on paper (and of course operation 'air head' immediately comes to mind) the reality may turn out to be more complex. Remember theory is grey, but life is green. Also worthy of comment is the 'good' deflation 'bad' deflation dichotomy. Virtuous deflation does exist: in some sense we can see an example of it now in China. Prices in some sectors fall in such a way as to produce a general economic expansion. History (in the nineteenth century) or contemporary reality (in China) does also tend to indicate that this virtuous deflation has its own attendant convulsions, as those thrown out of work in the backblast of creative destruction know to their cost. In a sense the 90's was a period of positive sectorial deflation in the US. A dramatic fall in prices in a number of sectors produced a historic expansion 'lifting all boats'. But if the fall in prices, due to the relevant cross-elasticities, fails to provoke real revenue growth in the affected sectors (think post March 2000) then the result can be slowdown and growing output gap.

So then you have to look at what's happening in the rest of the economy. This is what determines in the final analysis if 'good' deflation turns bad. Now conjuncturally we face two other negative headwinds. Firstly China. Of course, in other times, China would be producing the kind of 'healthy' deflationary tonic we all hope for. Falling prices in manufactured products stimulating a general market expansion, and growth all round. But this is not what is happening. China - entering sixth place - is giving the global economy what little push it has, but that is not sufficient to achieve lift-off. It is being more than compensated for by what appears more and more like an irreversible, 'historic', decline in the number two and number three slots: Japan and Germany. So we have what Stephen Roach (see my post yesterday) comes near to calling (and I will call) a negative feedback dynamic. As pricing pressure in the slows down the activity of the large global corporations in the developed economies, this ironically only increases the pressure to outsource in China. Ergo: not only may China be insulated from the growing global slowdown (SARS is another question), it may actually be a positive beneficiary of it.

Secondly, there is the demography. If Japan and Germany are moving backwards, there must be a reason. Simplistic calls for structural reform entirely miss the point. The reason is negative demographics. This argument is explained in interminable detail here>, and here and here. Since this phenomenon, in greater or lesser measure, is about to hit all the developed economies, then the plight of these two may give us some measure of what is to come. All in all then, whilst I think the deflation preparations of the Fed are admirable (in the sense that they are at least trying to do something, and doubly admirable in the light of the complete absence of preparations here in Europe), I think we still have a long way to go before we really start to get the measure of this one.

Most Federal Reserve officials think the U.S. economy will revive once war doubts lift but with corporate pricing power hamstrung, they are still bracing to avert a threat they hope never arises -- deflation.While Fed policymakers have expressed confidence the United States won't suffer Japanese-style deflation, in which falling consumer prices drag the economy lower, part of that faith reflects a willingness to act aggressively if needed."We don't want to get into a position where we get extra headwinds in an environment where we're fighting some other headwinds and that underscores the importance of being ... aggressive and willing to act preemptively." explained Vincent Reinhart, a top adviser to Fed Chairman Alan Greenspan.

The U.S. economy hit a brick wall of war worries and bad weather in February, fueling concerns among some analysts that the stop-and-go recovery was in danger of stopping altogether. Early readings on March appear little better. For its part, the Fed has blamed much of the weakness on disquiet about the U.S.-led war against Iraq and its potential economic impact, saying growth was poised to pick up once war-related worries ease. Officials at the central bank are hopeful that the 12 U.S. interest rate cuts since early 2001 will be ample to stimulate faster expansion. But markets are not so sure. "The Fed thinks they're done but the economic news is not really cooperating," said Bill Dudley, chief economist at Goldman Sachs. "The most likely thing is the Fed's on hold for the time being and we wait to see how the data, the war and the markets behave," he added.

While rising oil costs have pushed overall inflation up the past year, so-called core inflation, which strips out food and energy costs, has been slowing -- the Fed's favorite measure was up only 1.4 percent in the 12 months through February. With core inflation low and the economy weak, some analysts see a risk the United States could end up like Japan, which has been in and out of recession since equity and real estate bubbles popped more than a decade ago. With the benchmark overnight lending rate now at a 41-year low of 1.25 percent, the Fed has had to face the unsettling prospect that short-term interest rates alone might prove an insufficient tool if the economy weakened sharply.Many analysts believe the central bank would be loath to cut rates to zero because that could cause problems in money markets, which count on a positive rate of return to function."That's an issue that's getting a lot of attention these days and we'd have to make that kind of judgment in the context of everything that might be happening," Richmond Fed President Alfred Broaddus told reporters this week, while stressing he did not see deflation as a near-term threat.

Like Broaddus, Reinhart made clear the Fed was conducting due diligence for a prospect he called "quite remote." "You've seen the chairman testify (before Congress). A van pulls up and empties out with staff and they're all carrying briefing books. In an institution like that, what do you think we're doing?" Reinhart quipped when asked if the Fed had been giving more thought lately to how it might battle deflation. Speaking at an economic conference last week, Reinhart laid out a number of tools other than short-term rates that could be used to fight deflation, from pumping money into the banking system to lowering long-term rates by buying U.S. Treasuries. Officials express confidence such measures, while unusual, would prove effective, even while they admit a lack of experience makes it hard to gauge the likely impact. "As long as you're pumping out money at a faster rate then demand for money is rising you're going to stimulate spending," Dallas Fed President Robert McTeer said in mid-February. "I think it would be kind of fun to fight deflation, actually."

Officials in Washington repeatedly stress that the United States is not like Japan, where banking system woes have complicated efforts to spur growth. In Japan, falling prices have raised the burden of debt, adding to bad loans at banks and thus hampering new lending, which weighs on the economy and fuels more price declines. Fed researchers say that if a deflation threat arose in the United States, the key to avoiding a Japan-type spiral would be to act quickly while the now-healthy banking system could still transmit the benefits of an easier monetary policy.Even if prices were to fall, all deflation is not created equal. In December, one Fed official said deflation might not be so dire if it occurred when productivity -- or worker output per hour -- were rising rapidly, as it currently is in the United States. Since rising productivity cuts the cost of output, profits would be buffered even with falling prices.

Steven Kamin, a researcher at the Fed's Washington-based Board of Governors, said last week there was some merit to distinguishing between productivity-related "good deflation" and "bad deflation" caused by a collapse in demand. Still, he warned the economy could easily tip from good deflation to bad if hit by a negative shock. "The good part of good deflation is the productivity growth, it's not the deflation itself," Kamin said.
Source: Reuters News
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Japan Deflation Continues

Despite the recent oil price rise, Japan just registered its 23 consecutive month of retail sales decline.

Japan's nationwide retail sales have fallen 0.2 percent in February from a year ago, their 23rd straight month of decline. The drop compares with 2.6 percent fall in January and a 3.4 percent decline in December, the Ministry of Economy, Trade and Industry (METI). A record high jobless rate and falling incomes have made consumers reluctant to spend, with war in Iraq adding to uncertainty.Sales at large retail stores in February rose 0.2 percent from a year earlier after falling a revised 2.2 percent in January. Department store sales were flat in February while supermarket sales grew 0.3 percent year-on-year, METI said. The ministry said sales of automobiles and oil-related products had supported overall sales, while those of clothes and personal computers declined.
Source: Channel News Asia
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