The Thrust of Economic Policy vs The Force of Demography

2017 could be the year in which the thrust of economic policy collides with the force of demography.

For the past six or so years, economic policy-makers in ‘advanced’ economies have been frustrated by their apparent inability to engineer a return to the growth rates of the period between the recessions of the early 1990s and the onset of the global financial crisis.  From its post-crisis low in the first quarter of 2009, OECD area real GDP growth has averaged 1.9% at an annual rate, down from an average of 2.6% between the previous trough in the fourth quarter of 1990 and the peak in the first quarter of 2008.

Yet despite such an apparently sub-par rate of GDP growth, the unemployment rate across the OECD area has fallen from a peak of 8.1% at the end of 2012 to 6.3% as of late 2016, which is less than a percentage point above the lowest it has ever been since 1980. Over the last three years, the OECD area unemployment rate has fallen faster than over any other three-year interval in the last four decades. In the four largest OECD economies (the United States, Japan, Germany and the United Kingdom) the unemployment rate is at or below levels traditionally regarded as implying ‘full employment’: and, with the exception of the United States, this has been accomplished in the face of workforce participation rates rising to decade-or-more highs.

This apparent paradox – of apparently sub-par GDP growth nonetheless being sufficient to generate rapid (by historical standards) declines in unemployment – is largely explained by demography. Beginning in 2011, when the first of the post-war baby-boomers began turning 65, the growth rate of the OECD area’s working-age population – defined here not, as labour force statistics typically do, as the population aged 15 and over, but instead more realistically, given ‘norms’ about retirement ages, as the population aged between 15 and 64 – has decelerated much more markedly than it had done over the previous three decades. From an average of 0.7% pa over the decade to 2010, the growth rate of the 15-64 year old population in OECD member countries slowed to just 0.3% pa over the five years to 2015, and according to UN forecasts will slow to just 0.1% pa over the five years to 2020.

As a matter of arithmetic, the slowdown in the growth rate of the OECD area working-age population ‘explains’ about three-quarters of the ‘shortfall’ in OECD area real GDP growth since the end of the financial crisis, compared with the era before it. And it also largely explains why this ‘below-trend’ growth rate has nonetheless been sufficient to allow a significant decline in unemployment across the OECD area.

The rapid deceleration in the growth rate of working-age populations in ‘advanced’ economies (and in some ‘developing’ economies as well) has co-incided with the aftermath of the financial crisis, rather than being in any way a consequence of the financial crisis. Yet economic policy-makers appear to have ignored it, in calibrating their expectations for what constitutes an appropriate or desirable rate of economic growth.

The slow-down in the growth-rate of working-age populations, combined with the apparent slow-down in productivity growth in ‘advanced’ economies (which may be, in part, a legacy of the financial crisis) has resulted in a significant slowdown in potential growth rates – from about 2% pa in the years immediately before the financial crisis to less than 1½% pa in 2017 and 2018, according to OECD estimates.

When unemployment is high, aiming for real GDP growth above its potential rate makes sense, since reducing unemployment requires above-potential economic growth, by definition. But once an economy has reached full employment, continuing to push for above-potential real GDP growth is bound to lead, eventually, to higher inflation.

Incoming US President Donald Trump wants to use fiscal policy to engineer a faster rate of growth in the US economy, in much the same way that some interpretations of economic history hold that the Reagan Administration did in the 1980s (although those versions of history ignore the impact of the sharp fall in interest rates that occurred then, which cannot be replicated now, and the substantially lower growth rate of the US working-age population now than then). The Trump Administration also wants to redistribute economic and employment growth from other countries back to the United States through various trade policy measures – measures which may well provoke retaliation from countries adversely affected by them.

This prospect increases the prospect that, after more than five years of worrying about the risks of falling into deflation – a very unpalatable prospect, to be sure – 2017 may be a year in which both investors and policy-makers start to grapple with the opposite concerns.