HQ TrustJanuary 13 2021

HQ Trust’s Chief Economist, Dr Michael Heise: Review of The Great Demographic Reversal – Ageing Societies, Waning Inequality and an Inflation Revival

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Written by Dr Michael Heise, HQ Trust's Chief Economist

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With their book “The Great Demographic Reversal,” authors Charles Goodhart and Manoj Pradhan are causing a furor. After all, the two economists challenge the wisdom that inflation and interest rates will remain very low for a very long time due to the aging of the population. A review by Dr. Michael Heise.

Decades of an unparalleled increase in global labor supply are behind us. For the future, we must prepare for a progressive decline in the labor force, which has already begun in many Asian and European countries. Fewer workers, more retirees: How will global demographic shifts affect growth, inflation and interest rates, and how can the challenges be met? The central thesis of the two economists contradicts conventional thinking in several respects. The radical reversal of demographic trends will dry up the forces, they claim, that have kept inflation and interest rates low in recent decades and that have shifted the distribution of income in favor of capital and to the detriment of wage earners. The growth of our economies will slow, as is the conventional view, but it will also be accompanied by higher rates of inflation and interest and less income inequality. 

Is there an increase in the “dependency ratio”?

The central argument is that the world is facing a significant increase in the so-called “dependency ratio,” which will prove to be inflationary. As the total number of young people not yet active in the labor force and of retirees will be increasing much faster than the number of people of working age, the “demographic dividend” that we have been enjoying in recent years will be turned on its head. With less people producing goods and services and significantly more non-working people in need of them, global supply will tend to lag behind global demand. Combined with a greater bargaining power of the workforce in wage negotiations, this will increase inflation. 

Also, real interest rates will tend to rise, because the older generations will have to reduce their savings, i.e. liquidate some of their assets, in order to finance consumption. The decline in savings will be greater than the decline in overall investment. Businesses will strive for a higher capital intensity of production to cope with a declining labor force. And governments will also have negative savings, as they need to stabilize social security systems and cushion the sharp increase in health care spending in ageing societies. 

What is changing in China?

Importantly, the authors emphasize that global forces are at work here. The emerging economies of eastern Asia, especially China, are of great relevance. For decades, they have exported capital (excess savings) and offered low cost labor, but are now also facing severe ageing. Developments in Japan, which seem to contradict the prediction of higher inflation and higher interest rates, have to be seen in an international context. The decline of the labor force and the ageing in Japan were paralleled by an unprecedented increase of labor supply on world markets, which generated downward pressure on wages and provided Japanese companies lucrative investment opportunities abroad. 

Goodhart and Pradhan present their analysis in a very clear and structured way. They consider various possible objections to their non-mainstream position. These include, for example, the consideration that advantageous demographics in India or Africa and automation processes could resolve the shortage of labor worldwide. This is certainly debatable, but the authors argue convincingly in my view that both factors will not change the fundamental trend. 

How can economies reduce their enormously high debts again?

Another difficult aspect of long-term inflation scenarios is the question of how the economies will cope with the enormous debt levels that have piled up due to the economic crises of the past and a virtually permanent monetary policy accommodation. The authors argue that it will hardly be possible to grow out of the high debt when demographics are holding back growth. Reducing government debt through budget surpluses also seems unrealistic, as spending needs will rise sharply, especially for social security systems. Some inflation will help to reduce the real level of debt, but this , the authors argue, will bring monetary policy to the stage, which, contrary to todays situation, is headed for an intense conflict with fiscal policy. 

In the long-run, the authors do expect tax increases. Regarding the corporate sector, they recommend better incentives for more equity and less leverage to reduce high debt ratios. But these measures, they believe, will not counteract the dominant influence on inflation and interest rates, that will come from demographic shifts. 

The book deserves praise for skillfully portioning the complexity of the matter due to manifold interactions in the global economy. It challenges conventional wisdom that inflation and interest rates will remain very low for very long due to the aging of the population. 

A highly recommendable book for anyone who wants to learn about the economic challenges of the future.