It’s the demography, stupid!
by: Gavyn Davies
- The growth rate in the labour supply. Most models (though not all) produce a relationship between real GDP growth and r*, and also allow GDP growth to be impacted by a change in the supply of labour. The labour force is now slowing down rapidly in most advanced economies. Since the capital stock is fairly fixed for lengthy periods, this will increase the capital/labour ratio in the economy, and the “abundance” of capital will both reduce the rate of return on capital, and the attractiveness of new investment projects. This reduces real interest rates.
- The dependency ratio within the population. When the number of dependents (young and old people) relative to those of working age is low, the savings rate in the economy tends to rise, because workers save more than retirees. When the bulk of the baby boomers were in the labour force before 2000, this caused a large rise in savings in the advanced economies, which triggered a drop in r*. This will shortly start to reverse as the baby boomers retire.
- The life expectancy of the population. If lifespans are expected to lengthen, while the retirement age remains unchanged, then people will choose to save more while they are in employment (or delay expenditure when retired, which is more difficult) in order to remain comfortably off until they die. This increases the savings ratio and reduces r*.
Although recent economic studies do not completely agree about the relative importance of these three factors , there is a consensus that, together, they have accounted for a significant part of the decline in r* since 1980. For the world as a whole (including emerging markets), Bank of England authors calculate that demographic composition and labour supply growth has reduced r* by about 1 per cent in the past 30 years. Carvalho, Ferrero and Nechio estimate that the demographic transition has reduced r* by 1.5 percentage points in developed economies since 1990. And Federal Reserve authors, in a significant recent paper, conclude that their demographic model accounts for 1.25 percentage points decline in r* and trend GDP growth since 1980. They say this is “essentially all” of the decline in these variable in the US over this period. Stanley Fischer quoted this estimate with approval in his speech last week.