Demographics and markets: The effects of ageing
Will the rising number of retirees cause inflation and help lift the economy?
by: John Authers
The Federal Reserve has an awful hunch. It suspects that the world’s shifting demographics, as longer lifespans and reduced birth rates combine to increase the proportion of the aged within western societies, have rendered central banks powerless to raise long-term interest rates.
That was the conclusion of a paper published this month by economists from the Fed’s research division, capping a debate that has intensified over the past year. Citing an example based on the changing age structure of the US population, they said: “The model suggests that low investment, low interest rates and low output growth are here to stay, suggesting that the US economy has entered a new normal.”
This has already created ripples. Last week Stanley Fischer, the Fed’s deputy chairman, said US interest rates were low in part for reasons beyond the central bank’s control, and added: “An increase in the average age of the population is likely pushing up household saving in the US economy.”
There is widespread agreement that the steady ageing of western populations over the past few decades — as the postwar baby boom generation neared retirement and birth rates among their children declined — has contributed to historically low interest rates. But there is an intense debate among investors and economists over how the pattern will play out.
All agree that society’s choices over how they treat the old will go beyond the obvious moral and social implications, but could also determine whether deepening inequality can be reversed, and whether the world can escape from low yields and low growth.
“The ageing issue is very emotional: who’s going to look after grandma?,” asks George Magnus, chief economic adviser at UBS. “As an economic issue it looks dark and impenetrable.
But demographics is not destiny. We need political courage to do this, and we need more of it.”
Measures such as later retirement, incentives for carers and part-time workers and more immigration can all mitigate the effect of an ageing population.
Impact on growth
The mechanics of how we arrived at this point are straightforward. People save most during their working years. This prompts them to buy bonds either directly or mostly through pension contributions, pushing down yields. Then in retirement they consume more than they save — and in the final few months of life tend to consume more, in expensive healthcare, than at any other time. Greater longevity has accentuated this by ensuring more people live to see an incapacitated and expensive old age. This tends to push yields upwards.
The new Fed paper suggests that “demographic factors alone account for a 1.25 percentage point decline in the natural rate of real interest and real gross domestic product growth since 1980”. This is a huge claim, as it implies that demographics — rather than fiscal or monetary policy, technology or other changes in productivity — are responsible for virtually all of the decline in economic growth over the past 35 years.
As this period also saw increased savings activity as baby boomers scurried to get ready for retirement, slow economic growth was accompanied by long bull markets in both stocks and bonds in the US. Thus the phenomenon of ageing baby boomers helped to explain rising inequality. Increasing asset prices raises the wealth of those who already have savings, while a lack of bargaining power kept wages down for the rest.
But as the chart (top left) shows, the US, western Europe and Japan have all reached the “tipping point” when the numbers of people in work compared with old and young dependants has peaked and started to fall. In all three examples, that moment came just as the country suffered a major market crash. But the growing weight of the elderly in society has not, yet, started to push up interest rates, which remain at historically low and sometimes negative levels.
The Fed research paper suggests the effects could be permanent. It is common to blame either loose monetary policy or the overhang of debt from a crisis. But the Fed economists warned of a “risk that permanent effects of demographic factors could be misinterpreted as persistent but ultimately transitory downward pressure on the natural rate of interest and net savings stemming from the global financial crisis”.
In short, low yields may be unavoidable and much of the current policy debate may be misguided.
Their suggestion that the “scope to use conventional monetary policy to stimulate the economy during typical cyclical downturns is more limited than … in the past” makes deeply uncomfortable reading for central banks already throwing everything they have at obdurately low growth.
Investors and traders have taken note. Marc Chandler, who heads foreign exchange strategy for the investment bank Brown Brothers Harriman, says conventional theories suggest that monetary or fiscal policy can increase aggregate demand, while the demographic hypothesis is more sombre.
“America’s working population is unlikely to materially increase over the next 20 to 30 years,” he says. “That means that periods of low growth and interest rates will last for a long time and is the material basis for the new normal. Moreover, the demographic forces at work in the US are also present in many other countries in Europe and Asia.”
What happens next is a matter of some controversy. Last year, a team of economists at Morgan Stanley headed by Charles Goodhart, a former member of the Bank of England’s Monetary Policy Committee, argued that the rising number of retirees would “reverse three multi-decade trends” by reducing inequality, pushing up yields and raising equilibrium growth rates. “Both the young and the old are inflationary for the economy,” they said. “It is only the working age population that is deflationary.” With the working age population shrinking, inflation could return.
Longer lives, and greater expense at the end of life, would only increase consumption, they argued. Housing was also an issue. “As nations get richer, the old stay in their existing homes, rather than go to live with their children,” the team pointed out. “They are already on the housing ladder. So they stay put.” In this way, ageing will mean increasing investment in housing, and will not lead to any release of equity.
The report also highlighted international factors. China’s rising population helped keep global growth going for the past two decades. Now, as the “one child” policy which was imposed in 1979 works its way through the age cohorts, there is an imminent demographic tipping point in China where the number of people aged between 15 and 64 peaked in 2013. That could mean less of a savings glut, and therefore less appetite to buy bonds — which will push up yields.
Morgan Stanley faced withering criticism but the critical point at issue is the deal that society is prepared to offer the elderly. If they hold on to their current package, then rates could rise fast. But many believe that package is no longer viable and must be reduced.
“Our political-economy assumption is that the contract that administrations have implicitly made with the elderly will continue … to provide support through pensions and healthcare,” said Mr Goodhart.
Many economists question that assumption. If the elderly are forced to accept a poorer deal, with later retirement ages and less help with healthcare and other costs, then rates could stay low and the economy stay trapped in a “new normal”. With an uncertain future ahead, workers would feel obliged to save at a greater rate while they were still employed. By working for longer, saving would continue for longer.
Mr Goodhart and his colleagues argue that the threshold for doing this would be very high, because attacking the elderly is politically difficult and “very unlikely until demographic pressures are already well under way”, adding that “administrations have typically responded only at the eleventh hour”.
Others disagree. Joachim Fels, an economist at Pimco, responded with his own paper earlier this year entitled “70 is the new 65: demographics still support ‘lower interest rates for longer’”. Mr Fels said:
“If you look at the data in more detail, people retire later and later in life and it’s those people who do the bulk of the savings who retire the latest. It’s the Warren Buffetts of the world, to take an extreme example. But there are many more people like that.”
The wealthiest find it easier to stay in work, and have a much lower propensity to spend what they earn. So, Mr Fels argues, this mutes the effects that ageing would have on markets.
Dividing the US labour force by income, he showed that the participation in work by the top 20 per cent after the age of 65 had increased dramatically in the past two decades, and was likely to continue.
He now suggests his paper should have been called “Is 75 the new 65?”. If retirement continues to be delayed, and people put more money aside when they are in work, then the tipping point for demographics when savings start to fall can be delayed by a decade or more.
Inadequate pension provision in many countries adds to the problem. In China, there is little or no social safety net. In the US where the “401(k)” pension plans offered to baby boomers have had disappointing returns, many reach 65 without sufficient savings and have no choice but to keep working. With countries steadily moving away from offering guaranteed pensions, and requiring employees to bear the risk of any shortfall, the incentive to save increases.
But Manoj Pradhan, part of the team that produced the Morgan Stanley report and now a principal at Talking Heads Macro in London, argues that the sheer political difficulty of giving pensioners a worse deal ensures that a big demographic shift towards lower savings can only be delayed, not averted.
“In Japan,” he says. “They are not able to back away because the elderly are a large part of the voting population.”
Participation in work by the elderly bottomed out and started to rise 20 years ago, he says, but has still not kept pace with rising life expectancy. In western European countries, in particular, it is still rare for people to work after 65. “The spread between retirement ages and average life expectancies is widening over time; the rise in retirement ages isn’t keeping up,” he says.
Several European countries, such as Spain and France, could widen their retirement ages greatly. But the furious Greek response to lifting retirement ages during the eurozone crisis shows it is still politically difficult to implement.
In the US, where it appears that many corporate and municipal pension plans will be unable to pay what they promised, courts have blocked pension funds from reducing payouts.
All concede that broader cuts in what the state promises to pensioners are very difficult. As Mr Fels puts it: “Raising pension ages pushes down yields. The same argument applies to cutting payouts. Some call this ‘pension reforms’. Others call it ‘default’.”
Mr Magnus suggests a middle ground in the debate. He says various “coping mechanisms” have helped to mitigate the issue, such as reforms in Japan, to encourage carers and provide incentives for women to work. But migration, another way to offset the problem, is now going in the opposite direction, threatening to create a skills shortage.
“Capitalism rewards scarcity, and labour will become comparatively scarce,” he warns, adding that low rates will not be a long-term phenomenon. “That will raise the return on labour relative to capital.
That will turn into a redistributive mechanism within society. That won’t happen in the next 12 months, but it is a logical consequence, and does mean higher rates eventually.”