Key Points from Book: The Great Demographic Reversal

The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival

Charles Goodhart, Manoj Pradhan

The summary below is key points from an excellent book discussing the outlook and challenges the global economy will face in the coming decades. This book is very well written, soundly research, and worth reading for all economic enthusiasts, strategists, and politicians to understand the global context of inflation and social factor that will impact asset prices over the long-term.

The increase in the working age population (WAP, aged 15–64) in China outstripped the combined increase in Europe and the USA from 1990 to 2017 over fourfold—China saw an increase of over 240 million while in the latter two WAP increased by less than 60 million and mostly in the USA. The participation of the working age population also tilted the scales heavily in China’s favour.

These two politico-economic developments, the rise of China, and the return of Eastern Europe to the world trading system, provided an enormous positive supply shock to the available labour force in the world’s trading system.

As a result, globalisation surged ahead, with trade flows over the years 1990 until 2017 growing by 5.6% per annum, compared to the growth of world GDP of 2.8%. In 2004, the share of world manufacturing output produced by China was 8.7%; by 2017, it had reached 26.6%.

Combining these two factors, the rise of China, globalisation and the reincorporation of Eastern Europe into the world trading system, together with the demographic forces, the arrival of the baby boomers into the labour force and the improvement in the dependency ratio, together with greater women’s employment, produced the largest ever, massive positive labour supply shock.

When such a positive supply shock to labour occurs, the inevitable result is a weakening in the bargaining power of the labour force. Especially in advanced countries, a fall in real wages has seen the economic position of unskilled labour as well as semi-skilled labour suffer relative to capital, profits and managerial and skilled labour remuneration.

No wonder that the deflationary forces have been so strong. During these 28 years, prices of durable manufacturing goods tended to fall regularly in most advanced economies, though perhaps slightly less so in more recent years. In contrast, services inflation in developed market economies, having initially fallen quite sharply in the 1980s, tended to stabilise from the 1990s onwards at nearer 2%,

First, the declining growth rate of the labour force will necessarily reduce the growth of real output, unless there is an unexpected and quite remarkable surge in productivity. Growth rates generally cannot be expected to recover, if at all, beyond the disappointingly slow levels of the years since the GFC (Chapter 3). Second, our highest conviction view is that the world will increasingly shift from a deflationary bias to one in which there is a major inflationary bias (Chapter 5). Why? Put simply, improvements in the dependency ratio are deflationary, since workers produce more than they consume (otherwise it would not be profitable to employ them in the first place), while dependents consume but do not produce. The sharp worsening in the dependency ratios around the world means that dependents who consume but do not produce will outweigh the deflationary workers. The inevitable result will be inflation. With the supply of labour shifting down, standard economics suggests that their bargaining power will increase, and that real wages and the relative income share of labour will start rising again. While this will have beneficial effects on inequality within countries, it will be inflationary as unit costs rise. Add on top of this an increasing tax burden on workers (which we explain below), and they may well raise their wages demands in order to secure a desired real wage after taxation.

Third, real, inflation-adjusted interest rates, particularly at the longer end of the yield curve, may rise (Chapter 6) because of the behaviour of ex-ante (expected) savings and investment. That the elderly will dissave is not controversial. Those who believe real interest rates are likely to fall or stay low clearly believe that investment will fall even further below savings—we disagree. There are (at least) two reasons to believe that investment will remain more buoyant than many believe. First, the demand for housing will remain relatively steady as the elderly stay in their houses and new households create demand for new construction. Second, the corporate sector is likely to invest in capital in a way that raises the capital-labour ratio, in order to boost productivity. In net terms, we believe savings are likely to fall by more than investment,

In effect, we are in a debt trap. Debt ratios are so high that increases in interest rates, especially at a time in low growth, may drive exposed borrowers into an unsustainable state. As a result, the monetary authorities cannot raise interest rates, either sharply or quickly, without running into the danger of provoking another recession, which itself would make everything worse. But that will leave interest rates, and the accompany flood of liquidity, sufficiently expansionary (accommodating, in Central Bank speak) that debt ratios are likely to increase even further.

Global capital was largely prevented from accessing China’s financial markets, while the early returns from China’s financial markets were not attractive enough for overseas investment to chase. As a result, global capital flowed into physical investment. Strict capital controls allowed China to maintain a competitive global advantage. That same strategy allowed financial repression to be pursued at home in order to direct the domestic pool of saving towards state-owned enterprises (SOEs) with government-owned banks as the conduit.

Pierce and Schott (2012) document the ‘surprisingly swift decline in US manufacturing employment’ over the 2000s (see Diagram 2.2), identifying the removal of the threat of future tariffs against China as the key driver of that decline. That changed, according to the authors, when the US Congress approved a Permanent Normal Trading Relations (the US equivalent of the MFN) status on China in 2000 and eliminated the threat of tariffs in the future. Without a friction like tariffs to justify the onshore presence of manufacturing jobs, the production of many goods left US shores for China.

manufactured goods are impossible to differentiate by their geographical origin. Regardless of where they are manufactured, these goods are usually tradeable, must match a global standard of quality, and must be cost-efficient relative to producers in other regions. If an economy manages to enlarge the share of the manufacturing sector in its economy at an early stage of its development, its labour productivity will converge with global standards faster and consistently.

Nabar (2011, IMF) finds a negative correlation between urban savings and the decline in real deposit rates. When banks fail to protect household savings, households tend to save more, not less, in order to achieve a ‘target’, whether that is for education or the purchase of a home. China’s household savings have also been linked to the lack of a social safety net, and importantly in the context of this book, to the life cycle of a population that is saving for retirement.

The excess of desired savings over desired investment in the AEs was driving the equilibrium real interest rate lower by itself, since the dependency ratio improved in the 1980s. The injection of excess savings from China and North Asia served to push interest rates even lower.

China’s working age population has been shrinking (Diagram 2.5), a reflection of its rapidly ageing population. The internal migration that had provided a seemingly endless supply of labour to the industrial zones has reached the ‘Lewis turning point’, a point at which the surplus rural labour supply no longer provides a net economic benefit through migration

On the capital side, China’s phase of rapid capital accumulation in the sectors that are connected to the global manufacturing supply chain has already drawn to a close. The collapse in the manufacturing complex and the property sector back in 2014–2015 has been followed by consolidation and capacity cutting rather than in more capital accumulation.

even though a substantial portion of the credit extended by state-owned banks to SOEs was linked to excess capacity, both banks and SOEs were reluctant to write them off. Even if banks could be recapitalised by the government, SOEs that wrote down substantial loans would not receive any further funding, and would probably have to lay off a substantial part of the workforce. Instead, banks ‘evergreened’ the loans granted to SOEs and allowed them to stay operational. The presence of ‘zombie’ firms in China is therefore at least partly a function of societal and political constraints. Instead of mass layoffs, workers voluntarily left for jobs in urban areas in the gig economy, or were let go in small numbers when SOEs merged.

As the labour force and population growth go into reverse, overall growth will slow down. Household savings are likely to fall, with consumption directed to ageing- and health-related services, in the absence of a full and proper social safety net. This may happen either directly, or indirectly via the government.

Japan’s government debt cannot be cancelled even if it is domestically held. Why? Because the ‘leakage’ via households is too big. The enormous stock of government debt is held almost entirely domestically, with a huge chunk held by pension funds. Let’s say Japan’s government decides to cancel its debt. That would impair the asset side of the balance sheet of Japan’s pension funds, which would make it virtually impossible for them to service the liabilities that are due to the household sector. Shocked by the loss of future retirement income, households would raise their savings immediately and the ‘paradox of thrift’ would then lead to a consumption collapse and push Japan into a depression. Thus, the ‘leakage’ of Japan’s debt cancellation via household spending is just far too big.

In China, both sides of leverage are on the same balance sheet (i.e. the government’s) since so much of the corporate debt in question was issued by state-owned banks to SOEs. The ‘leakage’ (i.e. labour employed by SOEs) is smaller. China’s state-owned banks have issued debt to domestic state-owned enterprises. If banks were to cancel the debt, it would create two issues. First, banks would have to take a hit to their capital in a discrete step—we will address this point just below. Second, it would be difficult to lend any more to SOEs. The SOEs would have to cut down operations and possibly fire a substantial part of their workforce. That’s the problem—this could lead to social unrest which the authorities do not want.

Once the ranks of labour in the SOEs thin out (a process that is already underway but will still take years to reach critical mass), cancelling the debt will cause far fewer negative spillovers.

the price for accruing a large stock of debt will be paid via a shortage of credit for consumption and for businesses in the services sector. Even though debt-equity swaps allow for a much smoother deleveraging, they will eat up bank capital as the value of swapped equity is slowly written down to match the realised value of the non-performing assets that had been financed by the debt in the first place. While bank capital is being eaten away, and while real wage growth finds lower support from capital accumulation, the ability and willingness of banks to lend will be lower. Thus, even though consumers and the private sector account for an increasingly larger share of the economy, they will not be able to draw upon future earnings to consume or grow faster today. In summary, the future holds a much weaker path for the Chinese consumer, but a stronger rebound in productivity (particularly for the SOEs that work aggressively to reduce non-performing assets and loans ). Debt run-off is likely to reinforce these trends—it will not create a crisis, but it will constrain the flow of credit in the future as banks digest the excesses of the past.

For China, the implications of everything we have discussed are threefold. First, China will no longer be a global disinflationary force. If anything, demographic pressures and the Lewis turning point imply that inflationary pressures, with which the economy has never had to deal until now, could materialise and catch us off-guard. Second, falling savings related to the ageing population and to the end of financial repression will push the current account into deficit. The capital account, as we discussed earlier, could push the current account back into surplus, but it is not clear how the contrasting flows in household wealth, financing of the Belt and Road Initiative and foreign investment within China will play out in net terms. Without the persistent ‘uphill’ flows of capital that China’s earlier current account surplus had engendered, USA and global bond yields (and in turn asset prices) will see a reversal of the support from this source they had in the past. Third, China’s ability to introduce labour-saving and productivity-enhancing technology depends on the not-inconsiderable innovations that can be generated at home. Without the help of foreign firms transferring technology, and with political sensitivities around the acquisition of foreign technology firms by Chinese firms, an organic improvement in technology will be more difficult.

The danger facing the global economy is precisely that the economies that have dominated global growth are facing the biggest demographic challenges. And that means even if the world as a whole still faces substantial population growth going forward, the economies that shaped global growth for the last 35 years are the ones which bear the brunt of the demographic headwinds . Put differently, if demography is to leave only a scar on the global economy, then the economies that have done very little for global growth in the past few decades are the ones that must do much, much more in the future. Seen from this perspective, it should be clear that the disruption from technology that many fear so much in the advanced economies is actually an imperative without which the damage to global growth could well be far worse.

Indeed, many have explained part of the slower recent slowing of productivity gains as due to the ageing of the ‘baby-boom’ cohort. But as discussed in greater length in Chapter 10, this view is being reconsidered. Even if productivity does not, in fact, suffer from higher participation of the elderly, there could be a problem over promotion. If we pressurise the old to continue in work, will it cause blockages for the young? Next, a comfortable retirement is perceived as part of inter-generational equity and fairness. Finally, the old have typically had a much higher propensity to vote than the young. It is politically risky to seek to remove benefits from the old that they had perceived as their just reward.

The harder it becomes to find and hire qualified workers, the more employers will be forced to raise the productivity of those that they can attract and maintain in order to remain competitive;

Next, some of the sluggish growth of productivity per worker in the last few decades may be due to a combination of technology, shifting jobs from semi-skilled to unskilled, as discussed subsequently in Chapter 7 on ‘Inequality and the Rise of Populism’, and, perhaps, the growing participation of older workers.

Finally, an ageing population tends to consume services, such as care and medicine, where productivity increases are harder to obtain than in manufacturing,

The basic problem is that ageing is going to require increasing amounts of labour to be redirected towards elderly care at exactly the time that the labour force starts shrinking.

In the old days, people were mostly free of dependency cares from around 40 until retirement, when their earnings were highest and the prospect of retirement coming into sight. That encouraged saving. Nowadays people will be most free of dependency caring in their 20s, when earnings are lower and the prospect of living until 90+ almost unimaginable. Not a good time for saving. Then from 30 onwards, in some cases continuously, until your own retirement, looking after your own children12 would be followed in short order by the need to help look after your parents. See Bauer and Sousa-Poza (2015, 2019). Looking after dependents, whether children or elderly parents, takes time, effort and money. Given a combination of immediate emotional ties and time discount, we tend to believe that support for dependents will take precedence over saving for an uncertain future. In other words, we see the changing life cycle as a force likely to reduce the personal sector savings ratio and to throw a yet higher fiscal burden on the public sector to provide acceptable standards of living and health care for the elderly.

Inflation is the outcome of several interacting forces. These include underlying structural trends, demography and globalisation, and the macro-economic balance between savings and investment, as well as purely monetary phenomena.

If we are right in our political economy assumption that the social safety net will remain in place, then the age profile of consumption will continue to be flat or even upward sloping. The elderly will depend on (and vote for) government support and continue to save too little for the longer life they have inherited. The ineluctable conclusion is that tax rates on workers will have to rise markedly in order to generate transfers from workers to the elderly. Workers, however, would not be helpless bystanders. Labour scarcity in AEs (and some EMEs) will put them in a stronger bargaining position, reversing decades of stagnation in AEs. They will use that position to bargain for higher wages. This is a recipe for recrudescence of inflationary pressures.

The renewal of upwards pressures on inflation stems from three interacting and interlocking viewpoints: An intuitive balance based on the dependency ratio; An exercise based on labour market demand and supply, otherwise known as the Phillips curve; and A consideration of the relative balance of savings and investment in the (non-financial) private sector, and the effects of this on the public sector, and its policies.

Almost by definition, an improvement in the overall participation rate is deflationary, as workers outstrip those who do not work. As the dependency ratio falls, the disinflation from more workers overwhelms the inflationary impact of dependents. By the same token, a rise in the dependency ratio will be inflationary (too many mouths chasing too little food).

Dependents (the young and the old) are purely consumers and hence generate an inflationary impulse, whereas workers can offset this inflationary impulse through production.

switching from a deficit to a surplus when age-related expenditures are going to skyrocket will be extremely painful, and we think not politically feasible. Inflation then becomes a way that macroeconomic balance is restored.

Ben Bernanke (2005) famously attributed the declining real rate of interest from the 1990s onwards to a ‘savings glut’. This was down to two drivers: first, baby boomers saving for their future retirement and, second, by the ageing, but increasingly prosperous workers in Asia (especially in China) saving for their old age due to an inadequate social safety net. The result was that household savings ratios were high. But as the baby boomers retired, and the ratio of the old (individuals who were dissaving) to workers (who were saving) rose, the household saving ratio started declining. We plot the personal sector savings ratio against the dependency ratio for a selection of countries below, indicating that as the dependency ratio worsens (i.e. rises), the household savings rate falls (Diagram 5.1). Diagram 5.1 The household savings rate falls as the dependency ratio worsens (Source OECD)

From the point of view of the young, staying at home means they can save on rent and other amenities. But they need to allocate those savings for the future use, e.g. for housing down payment, or indirectly by building up human capital. From the point of view of parents, these social changes will then be reducing the prime period of saving for retirement by a large chunk (reducing that period from, say, 45–65 to 52–67).

If so, then that would lead to higher profit margins, a greater share of profits in national income than otherwise, and lower investment. In a recent NBER Working Paper, Liu et al. (January 2019) have argued that the continuation of very low interest rates has itself led to greater market concentration, reduced dynamism and slower productivity growth.

The development of software, for example, requires a lot of human skills and effort, but relatively little fixed investment. Insofar as technology is shifting the balance towards human capital and away from fixed investment, the ratio of expenditures on fixed capital to total revenues and output is likely to decline, possibly quite sharply.

In any case, we claim that growing labour market tightness will raise wages and unit labour costs. For such reasons, we think it quite likely, though far from certain that, in future, investment per worker will rise.

Their main conclusions, with which we agree, are: overall growth and total hours worked will slow down as ageing advances (which we can see because β3—which represents the coefficient on the aged profile of the population—is negative for growth and even more so for total hours worked); both the proportion of young and old are inflationary for the economy—this can be seen clearly by the coefficients for inflation of β1 and β3; and both the investment and the personal savings ratios fall thanks to demographics—as seen by a negative value for β3 for both investment and the personal savings ratios.

Slower population growth will lower savings (assuming a constant dependency ratio), but will equally lessen the need for more capital, houses, equipment, etc. However, this doesn’t tell us whether the capital/labour ratio will fall or rise, thereby raising or lowering the marginal productivity of capital. With both ex ante S and ex ante I moving in the same direction, assessing the likely balance between the two becomes problematic. The behaviour of household savings according to the life-cycle hypothesis in the presence of a social safety net and the impact of ageing on China’s savings explain why savings will fall.

Almost inevitably, health expenditures will rise further (Diagram 6.2), while the retirement age simply hasn’t kept up with longevity. Both health expenditures and expenditures on public pension transfers (Diagram 6.3) will continue to rise along with the ageing of AE societies. So far, measures to enforce participation in the labour force by raising the retirement age have not materialised, except in a handful of places which have enforced a modest increase in retirement age. Longevity, on the other hand, has gone up significantly thanks to medical advances and might go up further if the science of ageing makes rapid advances. As a result, the gap between longevity and the retirement age has been increasing in line with increases in longevity,

The economic impact of China on the world economy has been great. One dimension of this has been to impart upward pressure on the price of raw materials including, notably, oil. Much oil has been produced in relatively sparsely populated countries (Saudi Arabia and the Gulf and Norway). With China’s growth declining, and with the need to shift from fossil fuels to renewables, the net savings and current account surpluses of the petro-currency countries are likely to erode.

There will be a rising cost of labour and a falling cost of capital. We cannot think of any other time in history when the prices of the two main factors of production will be moving as clearly in opposite directions. Even before demographics start pushing wage growth up, the price of capital goods has already been falling. As wages begin to rise, compensating for more expensive labour will be easier thanks to a lower cost of capital goods. The resulting increase in productivity will somewhat temper the increase in wages and inflation. The savings and investment lens gives us another way to view this response. Given significantly cheaper capital goods, the cost of accumulating a given stock of capital uses up a smaller amount of the economy’s stock of savings. To some extent, this can counter the savings deficit created by ageing demographics and somewhat temper the rise in both the interest rate and wages.

it highly likely that the fiscal position will not move sufficiently strongly into surplus to offset the larger deficits that we expect to see within the private sector. Because fiscal deficits were not sufficient to equilibrate the economy over the last 30 years, central banks were forced to do so by lowering interest rates, ‘the only game in town’.2 In the same way in future, we expect real interest rates to have to rise in order to play the same equilibrating role because the public sector will not save enough.

‘Why Have Interest Rates Fallen Far Below the Return on Capital?’ (2019), has been that aversion to risk and illiquidity has driven an increasing wedge between the return on capital and riskless interest rates. Because the required return on capital remained high, thereby deterring investment, riskless interest rates had to be lower in order to equilibrate the macroeconomy.

What does remain a serious question is why conditions in which profitability has been so high, and both equity prices extremely high and interest rates so low, has not led to a much greater demand for corporate investment.

During these last 30 years, central bankers have remained the best friends of Ministers of Finance. By bringing interest rates steadily downwards, they have enabled the debt burden of sharply rising debt ratios to be completely offset. In future, this is going to change, and in a way that will make life for both those parties more difficult. Rising nominal interest rates, at a time when the prospect is for continuing, and, in some cases, worsening fiscal deficits, and still sharply rising debt ratios, is going to make the life of Ministers of Finance, and Prime Ministers, considerably more problematical. Moreover, the rise in debt ratios in the corporate sector, outside of the banks, is going to mean that the attempt to maintain the inflation target may leave the corporate sector, and the macroeconomy, at greater risk of default and recession.

Although global inequality has started to fall, as inequality between countries has declined quite sharply, inequality within countries has in the vast majority of cases risen, in many cases rather strongly, reversing the decline that took place from about 1914 until about 1980. Thus, the earlier hypothesis, embodied in the Kuznets2 curve, whereby economic development would initially cause inequality to rise, but peak and then fall continuously, appears to have become refuted.

There are two main constituent reasons for such trends in inequality. The first, already discussed in Chapter 3, is that trend growth in the returns to capital have been much stronger than the increase in real wages over this same, three-decade, period. The second main constituent reason for the increase in inequality is that the return to human capital, as proxied by educational attainment, has risen alongside the return to fixed and financial capital. In contrast, the return to muscle-power and simpler repetitive tasks has stagnated.

The implication of all this, i.e. that the very poorest have been protected, whereas the return to human and fixed capital has soared relative to the return to the unskilled and semi-skilled, has been that the lower middle class, say between the 20th and 70th income percentile, has come out the worst. Another aspect of this same phenomenon has been that mid-skilled jobs have fallen relative to both low- and high-skilled jobs, see Diagram 7.4, so that those in the lower middle class who could not raise their human capital were forced back into lower skilled jobs,

why would such technological developments change the slope and/or position of the Phillips curve? With the same level of overall unemployment, why would the associated aggregate wage/price outcome be less? Here the suggestion is that workers in the unskilled (gig) economy may have less relative bargaining power, and are less unionised, than those who previously worked in semi-skilled areas.

Demand management, and full employment policies, greatly strengthened the bargaining power of workers and trade unions. The alternative to not agreeing to the employer’s wage offer would be another job elsewhere, rather than unemployment. Also, as noted in Chapters 3 and 5, demography led to an improving dependency ratio. Union membership generally rose until about 1980

The growing bargaining power (relative to employers) of labour between 1945 and 1980 meant that the underlying NRU was increasing commensurately, perhaps to as much as 5.5%. It is deeply ironic that Keynesian demand management led inexorably to a much higher NRU.

Thus the fact that the slope of the calculated relationship between unemployment (or the output gap) and wage (price) inflation appeared to become more horizontal in these later decades may be just an artefact of better monetary policies and fewer supply shocks, rather than representing any change to the underlying structural relationship.

This finding has several implications. First, as long as there remains a sizeable buffer of elderly still prepared to switch elastically between work and retirement, then the Phillips curve will appear to be more horizontal, since employers can fill job vacancies from that source (as well as from migrants) rather than having to raise wages. Second, the existence of a reserve army of elderly has meant that the NRU will have fallen, since one can run the economy at a higher pressure of demand so long as that reserve army acts as a safety valve.

the CSI index provides a new window on movements in the rate of inflation. Because the CSI index tends to focus its weights on sectors with locally determined prices, it provides a way to separate out prices that are domestically determined from prices that are heavily influenced by international conditions. By using both inflation components and filters that eliminate trends and focus on cyclical variation, a different picture of the stability of the Phillips curve emerges. Whereas the standard accelerationist relationship between changes in inflation and gaps has flattened, the relationship between the weighted cyclical components and cyclical activity is substantially more stable.

not only is the long-run Phillips curve vertical at the NRU (u*), but also the position of u* is continuously and systematically shifting owing to longer-run demographic, political and economic forces.

The wedge between the 1% growth rate of Japan’s total output and the 1% average decline in its workforce is the contribution of productivity. Diagram 9.1 shows Japan’s outperformance over almost every advanced economy when it comes to output per worker.

Japan’s corporates showed a dynamism in overseas investment that was in sharp contrast to the desultory performance at home. O-FDI appears to be a safety valve designed to escape headwinds from local demand and expensive labour in favour of the dual tailwinds of strong overseas growth and cheap labour delivered by global demographic tailwinds. O-FDI was strong even during the ‘lost decade’ and has continued its rich form since.

Corporate Japan aggressively reduced the leverage it had built up at home. The domestic debt/GDP ratio for non-financial companies fell from a peak of 147% of GDP in 1994 to 97% of GDP in 2015, offset by public sector leverage that rose throughout that period. From the point of view of the corporate sector, however, leverage had to be reduced. Basic math says reducing the pace of borrowing or paying back debt when revenues are not growing means that other spending has to be pared back. That is what domestic corporate investment in Japan shows

IMF estimates (IMF 2011, Japan Spillover Report) suggest that labour costs are the prime motivation when looking at the shifting patterns of location and production, while growth in the destination country comes in second. METI’s survey suggests the opposite order as a rationale, by a wide margin. Firms’ responses suggest that 70% think demand in the destination market is the key motivation, while the importance of qualified and inexpensive labour has fallen in recent years.

Investment: the Yen value of outbound FDI increased threefold between 1996 and 2012, while the ratio of investment made in foreign affiliates, as compared to investment at home by domestic firms, increased 10-fold between 1985 and 2013. Number of affiliates: Japanese companies owned around 4000 overseas affiliates in 1987. That rose rather quickly to around 12,600 by 1998 and stands at 25,000 in METI’s 2018 survey. Employment: Overseas affiliates employment stood at 2.3 million in 1996. That number was 5.6 million in 2016.

The overseas capital investment ratio (the ratio of capital investment made in foreign affiliates vs domestic companies) stood at 3% in 1985, quadrupled to 12% by 1997 and reached 30% by 2013. The recent decline in the overseas-domestic investment ratio is one of the rare occasions that domestic investment has risen and overseas investment has fallen. Over the critical period when Japan’s corporate sector was written off, overseas investment has handsomely outperformed domestic investment

Japanese companies with overseas operations produced nearly 40% of their output abroad, while the overseas production ratio (manufacturing sector production by overseas affiliates compared to production within Japan) stood at 25% in 2017 (Diagram 9.6). For the key transportation sector, that ratio stands just below 50%.

‘Only a fraction of the profits generated from overseas operations are repatriated to Japan and a significant portion is reinvested abroad for further expansion of overseas operations’ according to Kang and Piao (2015). Why were profits not repatriated? If the objective of Japanese firms was partly to exploit lower labour costs and an expanding market overseas, then an external expansion would almost require profits generated abroad to be retained there for further expansion. The dramatic increase in capacity and employment abroad seems to suggest this is, indeed, what happened. Moreover, Japan’s ‘dividend exemption policy’ meant that firms were disincentivised from repatriating profits back home

One reason behind the downward pressure on wages in Japan can be traced back to the receding footprint of manufacturing and the expanding role of services, and hence in turn to the importance of the global factors that led to this reallocation. The local dynamics behind that reallocation are relatively straightforward: The aftermath of the asset bust and the two headwinds, tepid growth and an expensive and shrinking pool of labour, led to an investment recession. The manufacturing sector, least able to protect itself at home, begins to raise its productivity in three ways. First, it freezes any further increases in the capital stock and then slowly reduces its labour input. In doing so, the capital available per worker (a basic measure of productivity) slowly starts to rise. Second, manufacturing production slowly starts to get offshored. Third, selecting which activities to offshore completes the process—corporate Japan keeps the design and very high technology parts of the production at home and moves the more mechanical parts of the production line overseas. The manufacturing sector was unwilling to absorb its historical share of workers, and the share of manufacturing employment to total employment fell. The services sector (whose role in the economy was kept steady by the steady nature of consumption) began to face an increasing supply of workers. The share of services in total employment then rose. In order to protect its profitability, the services sector then drove a wedge between prices and wages, but by pushing wage growth lower. This was in part due to the dynamics we have described just above, but also partly due to the changing nature of Japan’s labour market as it sought out ways to escape its institutional customs. Bottom line: activity and jobs were reallocated both outside Japan’s borders and within Japan as the corporate sector strategically and purposefully raised productivity to protect itself. Those efforts need to better recognised not only for delivering Japan’s exit from the lost decade, but also with delivering productivity per worker that outperformed almost every other advanced economy in the world.

In Japan, the loyalty of insider workers is mostly to their company, rather than to a trade union, and the counterpart commitment from the employers is to maintain employment during downturns. So, the Phillips curve in this respect is very flat, with more of the adjustment to cyclical forces being felt in hours worked than in either unemployment or wages. Japan’s local customs of long-term employment make mass layoffs and job destruction unviable options.

The role of part-time, i.e. non-regular, employees grew as cost pressures increased. Their share in total employment rose from about 13% in 1990 to just under 30% by 2018. From the firm’s perspective, a fall in the ratio of insiders to outsiders was important very simply because ‘outsiders’ were not given long-term contracts which made their wages easier to suppress. So strong was the incentive to change this ratio that even in periods when full-time employees were actually being laid off, employment growth for part-time employees remained positive and even rose. In a nutshell, dimming prospects for growth required that firms reduce costs to protect themselves. The customs in the labour market, however, would not allow for a rapid, Western-type adjustment in which layoffs pushed the unemployment rate higher rapidly. Instead, firms employed a far more complex strategy that changed the structure of employment and forced wages and hours to do most of the adjustment.

Japan is not alone in seeing higher participation rates among the pre-retirement cohort. There are at least two reasons for this general trend. First, many have realised that they will live longer so that their planned savings look inadequate. Second, there has been a general degradation of pension benefits (designed to reduce the government’s fiscal burden).

Ageing economies can try to offset demography at home and abroad. At home, ageing economies have three options. First, use technology to offset the negative shock from labour to the production function. Second, raise the participation rate so that people work longer as well. Third, advanced economies can use some labour from abroad, particularly from emerging economies. If importing labour from abroad looks politically unrealistic, then perhaps capital can be exported abroad. There it can be converted into goods and services and repatriated to the advanced economies, the ones exporting the capital. The role of India and Africa—the demographically endowed parts of the world—has been advanced in this regard,

Elderly care in its broadest sense is a labour-intensive process, but it doesn’t necessarily add to future national output growth in a way that other services sector employment does. Put differently, much of patient care is a consumption good rather than a capital good that creates value even in the future.

participation rates of the workforce have already gone up considerably, thanks to greater participation of the 55–64 cohort and especially women. How much further can this rise in the future? In other words, if much of the increase in participation needed has already been realised today, there is less room for improvement for the future when the size of the demographic problem becomes more severe

Net migration flows into the AEs and out of EMEs peaked in 2007 at about 24 million each. When normalised against the size of the population, however, these flows are far too small to make a difference

this more direct route of transferring labour between economies is unavailable, then capital can flow to the labour abundant economies. These flows of capital can be combined with the local supply of labour in the labour-abundant economies to produce goods and services which, in turn, can be exported back to labour-deficient economies.

We think India will beat China in global growth over the next decade, and perhaps even the one after that. However, it will not be able to lift world growth the way China did for three reasons: First, the global environment is materially different in two ways. The decline in nominal and real interest rates during (and caused to no small extent by) China’s ascent created benign conditions at home in the AEs so that the ascent of China was not seen as a zero-sum game.

India has had a rich history of trading over the centuries, aided by empires that stretched over the bulk of its mass, but its disjointed social structure has often been a hindrance in creating a solid economic foundation.

Third and most important, India will be able to attract global capital to its shores, but the lack of administrative capital and its system of democratic checks and balances will not allow a single-minded, China-esque model of growth to materialise.

Inevitably, that means the private sector is to be the vehicle that drives India’s growth. In turn, it is the extent to which the private sector is able and willing to grow that will determine the path of India’s growth. Unlike the growth of SOEs under state patronage, the private sector needs an effective and level playing field to thrive. Thus, a lot depends on how quickly and efficiently India’s administration can reform and deregulate the economy.

Africa’s population in 2019 stands at approximately 1.32 billion, almost identical to India’s 1.37 billion residents, but it hosts that population over an area that is almost ten times the size of India’s 3.2 million square kilometres of territory. Over that area, Africa is made up of 54 countries. A key problem that Africa faces, therefore, is its fragmentation. Fifty-four national policies, each with their own domestic frictions like India’s, will mean a much greater problem when it comes to coordinating policies for growth. It also means that migration within Africa is far more difficult because of national borders than it is within India’s state borders.

emerging economies that cannot transform themselves into advanced economies fail not because of the so-called middle-income trap but because of an administrative trap.

Not only have interest rates already reached the effective lower bound (we discount the likelihood of getting policies to abolish cash ), but also we argue that inflation, and with that nominal interest rates, will most likely rise again. The problem is that the key macroeconomic sectors now carry such elevated debt ratios that any sizeable or sharp increases in interest rates would put large chunks of the private sector into solvency problems and add to the fiscal difficulties of Ministers of Finance.

just as raising leverage in banks increases the risks for other stakeholders, including the public at large, in exactly the same way buy-backs in other corporates is a risk-shifting activity.

Fundamentally, a regime of low and falling interest rates makes default on fixed income obligations less likely even if revenue growth slows down. Financially, the low risk of default makes the purchase of high-yielding securities far more attractive when the ‘search for yield’ dominates investment strategies. A combination of the two naturally led to the rapid growth of the issuance of relatively more risky assets.

Of course, if advantage had been taken of the extraordinarily low interest rates to extend the duration of the public debt, then the forthcoming rise in nominal official short-term interest rates would have less effect. But the felt need for an ever more expansionary monetary policy has led instead to a significant reduction in effective durations. In particular, a combination of QE and a ‘floor system’ of paying interest on commercial bank deposits at the Central Bank has meant that the equivalent volume of QE, backed by such deposits, has an effective zero duration. Thus, public sector fiscal finances will feel the full pain of any increase in official interest rates almost immediately. With corporate sector finances having become increasingly fragile, and (populist) political calls for keeping interest rates low, the Central Bank will become under intensifying pressure to keep any increases in interest rates gradual and limited. But if such interest rate increases remain gradual and small, then the present incentives to extend and expand debt finance remain in place. That is the debt trap in which so many of our countries have now become ensnared.

Real interest rates have become exceptionally low, partly because demographic pressures, particularly in China, have led to savings ‘gluts’, while investment ratios outside of China, as earlier argued, have remained extremely low, partly under the influence of the globalised availability of additional cheap labour. Both these factors are going into reverse. As the dependency ratio rises, personal sector savings ratios are likely to decline, unless governments consciously restrict the future generosity of their pensions and medical assistance for the aged, which could be politically challenging. At the same time the recovery in the power of labour, as workers become scarce, and taxation rises to meet extra public sector expenditures, will lead to rising real unit labour costs. In order to offset that, corporates are likely to increase their investment demand. So, the likelihood is that the balance between investment and saving, i.e. the demand and supply of loanable funds, may well lead to a recovery in real interest rates. If so, forthcoming pressures may lower growth rates, at the same time as real interest rates rise, making it increasingly difficult simply to grow out of current high debt ratios.

Finally, during periods of stress around debt, an income stream of fixed payments that is supposed to protect creditors turns out to be a dubious asset at best. History is littered with episodes of default on debt that have gone hand-in-hand with macroeconomic upheaval. Thus, even the benefits to creditors from holding debt versus equity are not clear and obvious.

mainstream approach to inflation has been based on monetarism and Keynesian demand management. To a monetarist, or to a gold-enthusiast, the answer to explaining such trends is straightforward. Advanced economies moved from a gold standard regime to a fiat money regime. Fiscal dominance allowed politicians to bribe the electorate with their own money and inflation ensued. Then stagflation took over in the horrible 1970s, and conditions got so bad that a move to Central Bank Independence (CBI) restored some vestiges of monetary constraint on politicians.

A consequence of the strengthening of labour’s bargaining power was that the Natural Rate of Unemployment was rising in the background, an ironic side effect of the deployment of Keynesian demand management to raise the average level of employment.

Inflation, it is regularly repeated, is a monetary phenomenon, and Central Banks can create money. How, then, can we have a persistent problem of lower than targeted inflation? Of course, we are told that this problem is due to the zero, or effective, lower bound to nominal interest rates. But when inflation remains around 1%, as now in 2019, the ELB only becomes a serious constraint when the equilibrium real interest rate, r*, itself becomes negative, falling far below its prior typical values of 2.5 to 3.5%. And that is a real, and not just a nominal, monetary problem. The mainstream explanation of our times is precisely that, an r* that has indeed become negative. The secular stagnation thesis involves a variety of arguments (inequality and even the need for ageing societies to invest less are in the mix), to explain why r* has fallen and will remain low for the foreseeable future. Empirical estimates of r* regularly show estimates that are negative or very close to zero, backing up the claims of the secular stagnationists.

Our approach differs from the mainstream in this field on at least three important issues. First, we are not as sanguine about the future of personal savings as the mainstream. The consumption assumptions of their models simply do not match the consumption dynamics that an ageing society will display. Second, we are more optimistic on corporate investment when faced with a declining workforce. We agree with Andrew Smithers that a serious governance problem in capitalist economies has hindered investment, particularly in the USA. Finally, the mainstream view sees debt and demography singing from the same hymn sheet in driving growth, inflation and interest rates lower for the foreseeable future. We see the two in conflict, with debt a gigantic block that the irresistible forces of demography will eventually move out of its way. In turn, that will put monetary and fiscal policymakers in conflict with each other.

Part of the answer is that investment, like production, has been off-shored to emerging Asia, see especially Chapter 9 on Japan. If so, the curtailment of globalisation will bring some boost to domestic investment. Another part of the answer could be that the weakness of labour bargaining power has allowed employers in the non-traded services sector to raise profits by lowering wages in the gig economy, rather than going through the more difficult process of raising employee productivity, notably via investment

Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate. The excessive debt, amongst non-financial corporates and governments will get inflated away. The negative real interest rates that may well be necessary to equilibrate the system, as real growth slows in the face of a reversal of globalisation and falling working populations, will happen. Even if central banks feel uncomfortable with such higher inflation, they will be aware that the continuing high levels of debt make our economies still very fragile. And if they try to raise interest rates in such a context, they will face political ire to a point that might threaten their ‘independence’.


About Journeyman

A global macro analyst with over four years experience in the financial market, the author began his career as an equity analyst before transitioning to macro research focusing on Emerging Markets at a well-known independent research firm. He read voraciously, spending most of his free time following The Economist magazine and reading topics on finance and self-improvement. When off duty, he works part-time for Getty Images, taking pictures from all over the globe. To date, he has over 1200 pictures over 35 countries being sold through the company.
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