- The role of demographics: U. S. evidence
- Demographic implications for Austria’s economy
Recently, in a closely followed speech Fed Governor Lael Brainard had defined the ‘new normal’ of the U.S. economy in the aftermath of the 2008/09 financial crisis referring to five key features (see UCM Weekly as of 19th September). Brainard also drew attention to the debate about the real neutral (short-term) and natural (long-term) rate of interest. Since 2012, the Fed’s estimate of the long-run neutral federal funds rate has declined from 4.25 % to 3.0 % implying a real neutral rate of 1.0 %. The summary of economic projections (SEP) released with the September federal open market committee (FOMC) revealed that the FOMC’s median estimate of the long-run fed funds rate had further declined to 2.9 % (i. e. a real rate of 0.9 %).
A staff working paper of the Federal Reserve Board that was issued last week tries to explain the role of demographics in understanding the low real GDP growth and low interest rates since the Great Recession in 2008/09 (referred to as the ‘new normal’). About 1 ¼ percentage-points decline in both real GDP growth and the equilibrium real interest rate since 1980 can be explained by the demographic structure accounting for observed and projected changes in U. S. population, family composition, life expectancy and labor market activity. Essentially, this would mean that all of the permanent declines in real GDP growth and the equilibrium real interest rate can be accounted for by demographic changes.
The U. S., like other advanced economies, is undergoing a dramatic demographic transition related to the unfolding of the post-war baby boom. The baby boom generation consists of the cohorts born after WW II through the mid-1960s. As a consequence, the growth rate of the labor force has declined and should remain low for the foreseeable future. The decline in real GDP growth since 1980 was caused primarily through lower growth in the labor supply. Interestingly, the author’s model also implies that the decline has been most pronounced since the early 2000s, so that downward pressures on interest rates and GDP growth could be easily misinterpreted as persistent but ultimately temporary influences of the global financial crisis. In the formal analysis, the dynamics of interest rates and GDP growth are most directly connected to the consequences of the post-war baby boom. As the baby-boom generation reached working age in the 1960s, the aggregate labor supply, GDP growth, and interest rates all increased. The abundance of labor was accentuated by the fact that the baby boomers had far fewer children than their parents did, leading the United States to reap a “demographic dividend” by which the number of workers relative to the number of dependents climbed to historically high levels by the turn of the 21st century. The demographic situation stimulated aggregate capital formation as members of an unusually large cohort with few dependents simultaneously supplied labor and aimed to save ahead of retirement. The low fertility rates of the baby-boom generation also supported the accumulation of capital by facilitating greater labor-force participation of women and by freeing resources that families would have otherwise allocated to consumption by children. Furthermore, steady gains in health and life expectancy have increased the amount of time households expect to spend in retirement, in turn boosting their desire to save. The baby-boom generation has since begun to retire and the growth rates of the aggregate supply and aggregate output have accordingly slowed. These factors have led to a current abundance of capital relative to labor, depressing the return on capital and also causing aggregate investment to decline; a phenomenon that is consistent with puzzlingly low rates of capital investment in the recovery from the global financial crisis.
The author’s model predicts that the capital-labor ratio will remain elevated despite low rates of aggregate investment in capital because the growth rate of the labor supply will also be low, so that both real interest rates and GDP growth will linger near their current levels.
How do the author’s projections look like?
The authors predict a prolonged period of low interest rates. The U. S. equilibrium real interest rate is projected to have fallen below 0.5 % in 2015, it is forecast to fall to around 0.4 % and remain at that level until 2030.
This is consistent with a further decline in the employment-population ratio and a rise in the inactive-adults-to-labor ratio over the forecast horizon. Real GDP growth is projected below 2 % roughly since 2008 and to slow steadily further to around 1.4 % in 2030.
The author’s real interest rate projection seems to coincide with the decline in the Fed’s projection of the (longer-run) neutral real rate of interest. While that kind of model does not capture business cycles, booms and busts or bursting bubbles, it does give a sound idea of the longer-run, trend GDP growth and real interest rates based solidly on demographic changes. It does not take into account positive technology shocks and innovations (arising for example from a digital revolution and corresponding productivity gains), which are by nature, difficult to foresee and require a different methodical framework.
Similar and mostly worse demographic forces (and slower technological progress) are also at work in Western Europe’s economies with Austria’s demography not making an exception.
Figure shows the annual declines (in five year periods) in the working age population that is going to intensify from 2020 onwards as large baby-boom cohorts reach the retirement age. The graph also depicts the ongoing rise in the retired population in Austria. Between 2025 and 2035 the working population is projected to decline by around 0.5 % in every year resulting in a large decline in labor supply and thereby driving down GDP growth.
Assuming constant growth in the capital stock and total factor productivity (average change since 2000), we estimate that potential real GDP growth could fall to below 1 % p. a. during that period.