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Analysis

Demography matters

Hazardous forecasts and economic effects

by Brian Reading

Fri 25 Nov 2016

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The question of whether weakening demographics will cause inflation and/or spur growth is neglected in the media. Attention is normally riveted on high frequency indicators such as monthly US employment growth. Population figures change slowly and are rarely newsworthy.

Nonetheless, they matter more for longer-term prospects than cyclical swings. In theory, demographic forecasts are more reliable than cyclical ones. In practice, they are hazardous. In the 1950s western students were taught the economics of a declining population. This followed the fall in birth rates in the 1930s depression and the second world war. Thereafter emphasis shifted to rising populations. More recently it has come full circle with attention being paid to pensions and productivity.

Demographic forecasts in a closed economy ought to be reliable. They examine the population’s age distribution, assumed longevity and the completed fertility rates for women past child-bearing age. These are then applied to women of child-bearing age. Medical improvements complicate longevity assumptions, as do life-style problems relating to poor diets and lack of exercise. Extrapolating fertility rates is hazardous. The rise in teenage and single-mother pregnancies must be set against the increased age of marriage and starting a family. Existing age groups may have the same number of offspring, but later in life.

Immigration into advanced economies is the biggest uncertainty. It affects population size, age distribution and fertility rates. In many ways, it is a blood transfusion to ageing economies, reversing population decline. On average, immigrants are younger and have higher fertility rates. In Britain 14% of women of child-bearing age are foreign born. Births by foreign born mothers account for 25% of the total. Massive immigration into, for example, Germany may turn demographic forecasts on their head.

Putting aside hazardous demographic forecasts, the economic effects depend on income distribution and savings. It is normally believed that in advanced economies the young borrow and spend, the middle-aged save, while the retired spend their accumulated savings. This does not work in countries like China, where a lack of consumer credit means the young save before they spend. The advanced economy model implies that an ageing population saves while an aged population spends. The old do not earn; they receive transfers from the working population, and savings rates fall.

The transfers come from pensions and the sale of assets to the young. These transfers are determined by politics and markets. Falling savings imply political and market obligations to sustain pension incomes are honoured. This need not be so. Demand-pull inflation is encapsulated in ‘too much money chasing too few goods’. Cost-push inflation can be ‘too many claimants chasing too little income’. The political punch of the old increases with their number. Workers’ market power increases with their decline. Cost-push inflation may be the solution.

Productivity and potential growth have slowed. Anaemic demand and excess savings have seemingly reduced the real equilibrium rate of interest. On the other hand, increased demand can spur growth and productivity, raising the equilibrium rate.

All of this has little short-term effect on markets. It does affect structural policies like raising the state pension retirement age, which would indirectly affect markets. Otto von Bismarck, the first German chancellor and founder of the modern welfare state, introduced pay-as-you-go old age pension insurance in 1889. Life expectancy was 45 years and the pension age was set at 70. It was a federal revenue cash cow.

Brian Reading was an Economic Adviser to Prime Minister Edward Heath and is a Member of the OMFIF Advisory Board.

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