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Demographics as a profound trend

Demographics as a profound trend

Summary: this paper reviews what is known about the demographic trends of the next 30-40 years, and looks at some of the implications of this. Three points stand out: that the old wealthy countries are indeed old; that this aging has substantial cost implications which will affect the economic performance and political stance of the countries which are most affected; and that the younger countries present potential which their institutions may make it difficult for them to harness.

Global trends

Global trends

Four out of ten Indians are under 15 years old, and India needs to find 15-25 million jobs every year, depending on how many of them remain in rural communities. India is, of course, around one billion people from amongst the four billion who live in low income countries, or in poverty in more wealthy nations. The demographics are, therefore, broadly representative of a poor world which needs to find, perhaps, 100 million new jobs every year to meet the potential demand. In the order of 2 bn middle class people will be living in modest affluence by 2020, around 500 million of them in the rich world and rest elsewhere. Asia will have more qualified professionals that the European Union or the US has citizens.

Not all poor nations are demographically young. China discouraged child bearing under Mao, and the male preference that further biased Chinese child survival rate - have made China broadly equivalent to many of the OECD nations, discussed below. The Soviet Union deterred reproduction through the gloom that it cast over lived, rather than direct admonition, but its former subject nations - and Russia itself - have extremely adverse demographics. Indeed, many of the former Soviet areas are now demographically where much of Europe will be in a decade. (The Islamic nations are, for the most part, excepted from this.)

In contrast to this pattern, the OECD nations have reduced their reproductive rates over the past two generations and as a consequence many now have or shortly will have a declining population. (Many have high net in-migration, which offsets these figures.) Many of the industrial countries are densely populated, and a flattening of population growth is, in all probability, ultimately to the good. It does, however, present a problem for those nations which have a demographic mountain to climb. Large numbers of dependent elderly people will need support during the many-decade period of this transition. The median age in the OECD will rise to 44 by 2020, and the number of those of working age, defined as those aged 20 to 64, will fall by about 38 million.

An important ratio which is used by demographers is the old age dependency ration. This is calculated as the number of people over 65 years old, divided by the number of people of working age, defined as above. This will rise across the OECD, particularly in the years after 2010, to reach almost 50 per cent by 2050. It is, at present, 22 per cent. This rise is, however, highly focused on some nations and much less pronounced in others. Italy will achieve 65% dependency by 2045, Germany and France some 50% somewhat later, and Japan will reach 65% in the same period. No nations have ever achieved such figures in recorded history. The issue is, however, chronic, as the ratio shows no sign of falling even after 2050.

These issues raise three sets of questions. First (and given the outcome of the sensitivities which are discussed below) what impact will age have on the economic performance of the currently industrialised nations? Second, what are the first order economic affects that are likely to arise from the changed balance between the 'young' and aging nations? Third, how will these alterations change the world view and political response of the nations in question?

The primary impact of aging on the wealthy nations

The primary impact of aging on the wealthy nations

Aging has a number of direct affects. Labour supply alters in quantity and quality, and with this, competitiveness and productivity are changed. Patterns of consumption and saving alter. Where dependency is not fully funded, the cost of support must be found in public sector spending, perhaps increasing net debt, certainly in altering the priorities in spending. Consumption may replace public investment; and the facilities in which investment is made are oriented more to the old and less to the needs of the young.

Aging also has a number of less direct affects. If there is a deficit in young people in the work force, then immigration will be likely to increase. The nature of the political process must be affected when the majority of the population are no longer young: both values and priorities may be expected to change. Issues as deep as urban planning or transport integration, and as shallow as package design and portion control, are all likely to be affected.

Let us focus on the primary economic issues. The long term dependency rates imply that public sector pension schemes will consume an additional 5% of GDP in the 'average' OECD country, and rather more in the nations with a highly developed problem. Naturally, this figure could be less if people worked longer, saved more for private pensions, had lower expectations of the state or died earlier. Health care is another claim on public spending, with about half of public expenditure going to those over 60 years old. On average, this amounts to 3% of GDP in 2006. The amount may be mitigated by private funding, by increased preventative care; but may also be worsened by expensive advances in medical technology. On balance, the OECD believes that an extra 3% will be allocated to health care. Other support programs are likely to consume another 2% of GDP, raising the composite expenditure on the aged by at least 11%, to around a quarter of GDP in the average nation, and by much more in 'focused' nations.

This expenditure could be funded by saving, or it could be a burden on state income. Presuming that it was funded from saving, then other factors - such as declining factor productivity, poor labour supply and related factors - would be expected to slow national growth by about 1% over historical trend. However, for the most part, it is not so funded. Italy has made only a few percent of the provision that it needs in order to meet current public guarantees on support in old age. The difference is a deficit. In the average OECD country, the so-called 'primary balance' between public income and expenditure will turn down by 7-8%. This means that the nation in question will have to raise taxes, cut other expenditure or borrow that proportion of GDP every year in order to balance the budget.

Simulations have been run for for a model OECD country, for which the demographic problems are less extreme than some of the nations already discussed. Even so, ageing leads to a debt-to-GDP ratio of about 200%, of which half is due to age-related spending and the rest to indirect slow down effects, debt service and so forth. (Assumnptions: Pension spending is equal to 8% of GDP. There is an initial primary surplus of 2.5% and debt to GDP is 55%. GDP growth is down to 2%, due to the reduced productivity growth, discussed above. Real interest rate is 4%.)

Such debt-to-GDP ratios are not sustainable, not least as debt repayment would become a major component of public expenditure. Countries with a debt-to-GDP ratio over 100% are regarded with suspicion by lenders, and most currently seek figures closer to 60%.

There are policy measures which can be taken to mitigate these very severe forecasts. If payments - or the number of payees - were reduced by 8-10% in real terms, then the debt-to-GDP would remain constant. If people worked longer, much the same could be achieved. The tendency in Catholic continental Europe for people to work less after passing 50 has dropped participation rates from 35 to 25% or less. Nations such as Finland, France, Italy, the Netherlands and Portugal have explicit penalties to older people to prevent them from working, and many have support structures - including disability allowances - that have a similar affect. Employment that is undertaken whilst deficit-funded pensions are being paid will, however, have only a minor impact on the overall bill.

By contrast, post-50 employment participation has remained high in the US, Sweden, Asia and Canada - over 50% on average - and shows no sign of decline. The impact of training on post-50 employability is very strong.

One thought which is frequently advanced is that the knowledge economy, coupled to information technology, will 'allow' people to work longer and will accelerate productivity growth. The European Union believes that a productivity growth rate that is one % higher than recent history could cut public expenditure by 1% relative to GDP. In the OECD as a whole, however, pensions are tied to income per capita, not to prices. Consequently, productivity growth of one % higher than expected will have a tiny - % - on public expenditure relative to GDP. To keep the real value of pensions but decouple these from national wealth has been an implicit goal of policy in the UK, but in few other nations.

Fundamental solutions come from adequate savings. The so-called "3 pillar" approach seek to give retirees three sources of income: from a state pension, from a compulsory fully funded pension plan and from a voluntary fully funded pension plan.

Private pensions have also been in difficulties in many OECD countries. In some instances, they have been overly-linked to national stock markets, as in Japan. The chief problem has been, however, the aftermath of the boom of the 1990s and the "pension holiday" which many companies gave themselves in respect of their obligations to these. They were able to do this due to the arcane relationship between actuaries and accountants, due to sanguine views on the nature of the knowledge economy and due to pressures to find economies during the boom years. The resulting overhang is estimated at $1 trillion in the USA and $170bn in the UK. Many major corporations are now found to have huge liabilities which affect their valuation and, in some instances, variability.

The figure shows how extreme the bubble was after 1994, and how relatively modest has been the subsequent correction. Ideas that the structure of value added had somehow been transformed by "e-" this or that - and that these sources were therefore mis-measured by conventional GDP - are now to be discounted. This was a bubble, first an foremost, and it follows no unexpected source of value is likely to emerge to reinvigorate the relationship between economic activity and the discounted value of the earnings of an asset. Savings will continue to yield modestly until asset prices come more closely into line with GDP. Looking at the figure, it is hard to see this happening in under a decade.

Nations such as the US and the UK have somewhat advantageous demographics as compared to much of continental Europe, Japan and others. Age-induced drag will slow these nations, whatever policy measures they pursue, by up to half a percentage point per annum as a result of labour supply drag and productivity differences. The Japanese lag may be up to 1% per annum. Additional and much larger affects will be added to this if corrective measures are not taken. It follows that a gap that is in the order of 25% of current GDP per capita will, at minimum, develop between these groups of industrialized nations, perhaps double that for Japan.

The indirect affects of demographic differentials

The indirect affects of demographic differentials

Some of the industrial nations face a heavy burden that appears to run well beyond 2050. The poor nations, by contrast, need to create jobs and for this they need markets, knowledge, capital and institutions which work. They need to be able to place their workers in those countries which desperately need modestly skilled labour. Indeed, the EU region may need a net influx of 30-40 million workers by 2030.

The poor nations face tariffs, the consequences of the development of China and other competitors for manufactured goods and services, potentially the impact of climate change and extremely rapid commercial change. Their societies have to adapt in ways for which they are ill-fitted, and many may choose to insulate themselves, or to turn away from the global economy into religious or other forms of exile. Some of these will continue to take on ideologies which demonize the industrial nations and seek a solidarity of misery. Those who do seek engagement with the world economy will, however, need willing partners if they are to succeed.

The wealthy world will fall into two obvious blocks, being those with 'good' demographics - supplemented by those with strong policies to encourage saving and long-term participation in the workforce - and those which have made poor provision, or failed to develop policies to ameliorate aging, or fallen into the traps set by both of these. The politics of those nations which are in difficulties are fairly predictable: a graying majority, perhaps accustomed to dependency on the state, will vote themselves more benefits. Even if they do not do this, they will be unlikely to curtail what they already have: either way, the pressures are not towards monetary or fiscal probity. They will borrow against an uncertain future and tax their working young, and the temptation to inflate their way out of locally-denominated debt will always be there. Sovereign debt may well become more costly to them.

Political outcomes: cooperation or polarisation

Political outcomes: cooperation or polarisation

The old rich of both of these camps are faced with formidable new competitors. Their monopolies of more or less everything except complexity management will be weakened or lost. As we have observed elsewhere, the "best" way to respond to this and other pressures may well depend on the innate nature of the games being played at the time. It may pay a country to be statesmanlike and open to competition from all sources, or narrowly bilateral and closed to competition.

Which way things tend will depend on the nature of international economics and, perhaps with much more weight, on the ethos of the international arena. If headlines are dominated by stories of terrorism and cartelisation, company closures and environmental catastrophe, then this Age of Anxiety will be more closed that otherwise. The poor will not get their partnership, and the rich will not get the easy flow of labour that they will need. If the news is relatively emollient and the economic stories are good - on how fine a partner China is proving, and how exciting its goods! - then the old world will become even more open than now. Genuine efforts at promoting development and partnership will see falling agricultural tariffs, for example; and rational measures will be used to tag, track and manage guest workers. Anxiety is thereby assuaged, and collective efforts can solve some of the problems of aging.

There are perhaps three weak points in this virtuous circle: the 'old' nations that are in particular difficulties, the rejectionists for whom partnership is fellowship with the devil, and Chinese triumphalism. The latter would be particularly hard to manage if it came with further, chronic high oil prices which, in the absence of a cheap, immediate alternative energy technology, it would. Just as painful to the 'old' nations might be a Chinese economic crisis, in that suddenly low oil prices would trip Russia and bring down a significant amount of speculative investment. The trigger is, perhaps, less important than the outcome.

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