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Developed Country Demographics are Inflationary, not Deflationary

I’m a relatively simple guy. I like simple models. I get suspicious with models that seem overly complicated. In my experience, the more components you add to a model the more likely it is that one of them ceases having explanatory power and messes up your model’s value. In this it is like (since tonight is Major League Baseball’s All-Star Game I thought I’d use a baseball analogy) bringing in relievers to a game. Every reliever you bring in has some chance that he just doesn’t have it tonight, so therefore you ought to bring in as few relievers as you can.

Baseball managers don’t seem to believe this, so they bring in as many relievers as they can. Similarly, economists don’t seem to believe the rule of parsimony. The more complexity in the model, the better (at least, for the economist’s job security).

Let’s talk about demographics and inflation.

Here’s how I think about how an aging population affects inflation:

  1. Fewer workers in the workforce implies a lower unemployment rate and higher wages, c.p.
  2. A higher retiree/active worker ratio implies lower saving, which will tend to send interest rates higher and equity prices lower, and tend to increase money velocity, c.p.
  3. A higher retiree/non-retiree ratio probably implies lower spending, c.p.

It seems to me that people who argue that aging populations are disinflationary don’t really have a useful model in mind. If they do, then it revolves only around #3, and the idea that spending will diminish over time; if you believe that inflation is related to growth then this sounds like stagnation and deflation. But if there’s lower spending, that doesn’t necessarily indicate a wider output gap because of #1. The best you could say about the effect on the output gap of an aging population is that it is indeterminate: potential output growth should decline because of workforce decline (potential output growth » growth in the # of workers + growth in productivity per worker), while demand growth should also decline, leading to uncertain effects on the output gap.

I think that most people who think the demographic situation of developed nations is disinflationary are really just extrapolating from the single data point of Japan. Japan had an aging population; Japan had deflation; ergo, an aging population causes deflation. But as I’ve argued previously, the main cause of deflation in Japan was overly tight monetary policy.

The decrease in potential growth rates due to the graying of the population is real and clearly inflationary on its face, all else equal. Go look at our MVºPQ calculator and see what happens when you lower the annual real growth assumption, for any other set of assumptions.

So, my model is simple, and you don’t need to have a lot of extraneous dynamics if you simply say: slower potential growth implies higher potential inflation, and demographics implies lower potential future growth. Qed.

One other item I would point out about the three points above: all three are negative for stock markets. If you truly believe that the dominant effects are lower spending, less savings, and higher wages the you can’t possibly think that demographics are anything other than disastrous for equity valuations in the future.

  1. CharlesD
    July 18, 2018 at 8:00 pm

    Nerdy note: Total financial savings over any period will always equal zero – at initial face values. Hence, it is generally not possible for individual savings decisions to impact the overall level of savings. Recall that all spending = all income – an identity. If financial savings = income minus spending – the difference is obviously zero. This result can also be understood by noting that for every new financial asset, there is a corresponding new financial liability. Hence, net new financial saving must necessarily be zero.

    For example, If you go to our National Income Accounts and add the financial savings of government (negative, of course), business, households and foreigners (US exports minus imports) – the total is very close to zero – close enough for government stats!

  2. CharlesD
    July 18, 2018 at 8:43 pm

    Correction: sorry, I meant the financial savings of foreigners from the US economy are US imports (income to foreigners) minus US exports (spending from foreigners) – not exports minus imports.
    Anyway, the overall result is interesting to ponder.

  3. Drew Wells
    July 24, 2018 at 6:19 pm
    • July 25, 2018 at 8:42 am

      Thank. The BIS paper is the better paper. Neither of them correct for monetary policy, which of course is the BIG effect on inflation. When you do that, even on an ad-hoc basis, the results are much clearer. Japan has been in non-flation/inflation due to contractionary monetary policy for the last three decades.

      I do think that cross-country makes more sense since a 60-year-old today isn’t the same as a 60-year-old twenty years ago, but there is far more to correct in cross-country comparisons than in time series.

      Thanks for the contrary viewpoint!

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