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

by Charles Goodhart

The rise of China and demography created a ‘sweet spot’ that has dictated the path of inflation, interest rates and inequality over the last three decades. But the future will be nothing like the past—and we are at a point of inflexion. As that sweet spot turns sour, the multi-decade trends that demography brought about are set for a dramatic reversal.

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.

In the USA meanwhile, the participation rate (share of labour force to population) declined by over 4pp during the same time—had it stayed steady, the unemployment rate would have been higher before the pandemic struck.

But there was yet another boost to the world’s effective labour supply, arising from the collapse of the USSR, following the fall of the Berlin Wall in 1989. This brought the whole of Eastern Europe, from the Baltic States, through Poland down to Bulgaria, also into the world’s trading system. The population of working age in Eastern Europe rose from 209.4 million in 2000 to 209.7 million in 2010 and is now projected to be 193.9 million in 2020.

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. The opportunity to take advantage of such newly available workers was reinforced by a general acceptance of economic liberalism during these decades, reducing barriers to international trade, with the trade rounds in Uruguay in 1986 and Doha in 2001.

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 p...

The first of these demographic features is the continuing fall in the dependency ratio during these years, i.e. a rise in the number of workers, defined as those 15 to 64, relative to dependents. And the second is the rise in the proportion of women in the working age group taking paid jobs.

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. The effective labour supply force for the world’s advanced economy trading system more than doubled over these 27 years, from 1991 to 2018

The last 30 odd years from the beginning of the 1990s to the present have been extraordinary for the global economy (Chapter 3). When such a positive supply shock to labour occurs, the inevitable result is a weakening in the bargaining power of the labour force.

Both a symptom of labour’s declining bargaining power and a further cause of it have been the steady decline in private sector trades union membership. This has been a common factor in most AEs.

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%, though perhaps declining slightly in the last few years.

These deflationary forces have been so aggressive that they have caused inflation to remain at, or more recently below, Central Bank targets, mostly set at about 2% over the decades from 1990 onwards. Even massively expansionary monetary policies and fiscal policies which have resulted in the largest and most persistent rise in public sector debt ratios ever during periods of general peacetime (apart from Germany—see Table 1.3 and Diagram 1.4) have had little success in reflating the global economy.

Finance has recorded some of the strongest effects of demographic change. Interest rates have trended steadily downwards, at least until about 2017/2018 (Diagram 1.5). With inflation remaining low, this has meant that real interest rates, i.e. after adjustment for the current inflation rates, have also been falling. Falling interest rates have led to rising asset prices. Despite some interruption from the Great Financial Crisis (GFC) over 2008/2009, this too has been happening, notably with equity and housing prices.

The gainers from all this have been those with capital, both embodied and human in the advanced countries, and workers in China and Eastern Europe. Thus, the ratio of the wages of an American worker to a Chinese worker, and of a French to a Polish worker, have been narrowing sharply, as shown in Table 1.4.

There are many more Chinese than Americans, so, just as income inequality within particularly the advanced countries has tended to worsen, income inequality between countries and in the world as a whole has been improving. Inequality, as measured by the ratio of the income of the top 10% to the bottom 90%, has tended to worsen within most countries, as has wealth inequality. This is recorded in much more detail in Chapter 7.

The rise in income and wealth inequality, and the slow rate of growth of real wages among the less skilled, had led an increasing proportion of voters in many advanced countries to lose faith in their political institutions, and to believe that the elite has ceased to care about them. For the first time since World War II, many, perhaps most, of the populations in our countries do not see any strong likelihood of an improvement in either their or their children’s economic well-being over future decades.

There was no political backlash before the GFC in 2008 because rising inequality within countries was offset by the general economic well-being of these years, often described as the ‘Great Moderation’. Indeed, in many ways, these were the best 15(plus) years for general economic success in the history of the world. Growth was steady, unemployment was low, inflation was stable and more people taken out of poverty than in any prior equivalent period.

If the rise of China and massive positive labour shock that the world has had to absorb seem as compelling to you as they do to us, why is this focus not commonly highlighted in general macroeconomic analysis? A basic problem is that most financial, macroeconomic and policy discussion relates to forecast developments over the course of the next two, or at the most three, years. During such a relatively short time period, the underlying trends, as represented by demographic factors and the effects of globalisation, generally move too slowly and steadily to affect the key features of the short-run, cyclical forecasts.

A related failing is that the factors that dominate short-term forecasting are then given too large a role when it comes to constructing a long-term view, while the slow-moving factors like demographics that surely dominate long-term change are still given too small a role.

Over the next three or four decades, the steady decline in birth rates, starting in the 1950s in many advanced economies, notably in Europe, to below the rate at which the population is self-sustaining, will bring about a sharp reduction in the growth of the labour force in many countries. There will be an absolute decline in the labour force in several countries—in the key economies of Japan, China and most of North Asia as well as several in continental Europe, such as Germany, Italy, Spain and Poland.

We are particularly enthusiastic about Chapter 4. It attempts to address a shortcoming of the literature by introducing a cross-disciplinary study of demography that integrates the medical perspective on ageing with the economics of the sharply increasing incidence of physical dependency and dementia. This chapter explores the medical progress in, and estimates of, the cost of detection, treatment of and caring for those afflicted by dementia.

Unlike the dominant diseases of our age, dementia does not curtail lifespans. Rather, it incapacitates those who are afflicted and therefore involves a large use of resources to care for them. Whereas medical science has made remarkable steps in treating cancer and cardiovascular diseases, both of which tended to kill quite quickly, there has been very little improvement in the treatment of dementia.

The further slowing of globalisation will reinforce ageing just as globalisation energised falling dependency ratios in the past. Globalisation is likely to slow because of two headwinds.

First, China faces not only a sharp decline in the number of those entering the labour force, but is also reaching the end of internal migration from the farming community in the western provinces to the manufacturing sector in the east (Chapter 2).

Second, while manufactured goods and some services can be produced elsewhere and then ‘shipped’ to their destination, this is virtually impossible when it comes to looking after the elderly. Advanced nations will therefore be increasingly reliant on their own resources, particularly the shrinking pool of their own labour force.

We then go on to explore first the broad economic effects (Chapter 3), and then the effects on inflation (Chapter 5), real interest rates (Chapter 6) and inequality (Chapter 7). Chapter 4 plays a dual role, explaining both the economic effect of ageing and also demonstrating the severity of the impact of ageing on the great demographic reversal.

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...

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 belo...

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, lowering the real interest rate.

Finally, we believe that inequality will now fall (Chapter 7). As the wave of populism and the success of nationalist right-wing parties have demonstrated, inequality within economies has risen to critical levels, even though inequality across nations has actually fallen thanks to the rise of China and Asia.

The most fundamental explanation for the rise in inequality can be traced back to the global surge in labour—and hence its reversal will also lead to a decline in inequality.

So more and more of us will live longer lives, but where are the resources which will enable the aged to consume after retirement going to come from, even if we abstract from the extra medical burden? There are three main alternatives, discussed at greater length in Chapter 6.

The first is that the age of retirement should be raised a lot, with people in future expected to work into their 70s. But, as described later in the book, there is no sign of retirement ages yet being significantly increased (with the exception that wo...

The second alternative is that workers finance their own retirement by saving more. This latter depends on the expected generosity of state pensions and the myopia of those in work.

Again, an important example is China, where the absence of a welfare state and the collapse of reliance on younger family members (as a result of the one-child family, where there is one grandchild for every four grandparents), has led in the past to very high personal savings rates. But in the West there has been relatively little sign, yet, of personal savings rising to meet the need to smooth lifetime consumption rates, even though the difference between life expectancy and retirement age has risen dramatically. Perhaps this is due to an expectation that the state will provide, or perhaps it is due to myopia.

An added complication is that the age of having children has increased in many advanced countries. With children remaining at home for longer, the years during which workers can save for their retirement, with no children to support, will decrease. The hope is that the savings that the children incur on what they would have otherwise paid for rent can then form part of household savings in the future—whether that pans out remains to be seen.

The third channel is for the state to tax workers, and use the funds to transfer the resources to the old, both for medical support and pensions. A key question is how the state will see the balance between higher taxes on those currently working, including workers of all levels of...

If one should assume that tax rates will remain constant at present levels, then the massive rise in the numbers of the old would mean that the relative generosity of pensions would have to decrease sharply, partially balanced by increased savings rates from those of working age. We do not believe that this is the right assumption to make, though it lies behind the assumption of interest rates remaining low over future decades in several other related studies of long-run demographic outcomes. Instead, we think that a better assumption is that pensions will go up in real terms in line with the r...

There are several reasons why we prefer this assumption to that in which tax rates are held constant. First, the pensions of the aged have generally been protected despite the slow growth of real output in recent years. Second, the old represent a major voting bloc, and they are more likely to vote than the young. The rising share of elderly voters in the elec...

The more prominent of these, Chapter 9, is that such a decline in the labour force has already been in evidence in Japan for over a decade, and that there have been no signs yet of any upwards pressure of wages, inflation or real interest rates there. Many consider Japan to be the blueprint for ageing and are therefore sceptical that our conclusions will hold for the global economy if none of them were in evidence in Japan.

The second is that the recent relationship between unemployment and wage, or price, inflation, commonly known as the Phillips curve, Chapter 8, has not yet shown any tendency for wage rates to rise as unemployment falls, in a large number of advanced economies. Indeed, unemployment has declined in many of our countries to the kind of levels that would have probably generated wage inflation in the last century, but there is as yet little sign of any resultant upsurge in wages. The Phillips curve has recently seemed flat, i.e. as unemployment falls, nominal wage growth remains more or less constant at low levels.

In the case of Japan, we argue that the decline in the Japanese labour force occurred at a time when the rest of the world was swimming in labour. Japanese businesses took advantage of the growing pool of labour overseas to offshore production to China and other parts of Asia. In other words, the ‘true’ available labour supply in Japan was Asian or even global, rather than purely Japanese.

Our view stands contrary to the conventional view of a dormant corporate sector weighed down by deleveraging. What is in stark contrast is the scenario that confronts the world today. As the labour market tightens in China and the bulk of the global economy, such offshoring will become more difficult.

Milton Friedman (e.g. 1968) popularised the concept of the Natural Rate of Unemployment (NRU). But the NRU is not constant. Perhaps the best definition of it is the rate that makes labour willing to accept that rate of growth of real wages that its own increasing productivity makes available. It then follows that the weaker is labour’s bargaining power, the lower will be the NRU. As labour power, and TU membership, has fallen, so has the NRU. This is discussed further in Chapter

While birth rates have been going down sharply in most of the advanced countries, this has not been so in much of the Indian subcontinent, and particularly not so in Africa. There will be a massive rise in the available working population in these parts of the world.

Just as the production of goods was shifted from the West into China over the last three decades, could a similar shift lead to the production of goods moving to the Indian subcontinent and, particularly, to Africa, where the rate of growth of the working population in countries like Nigeria and the Congo will be quite remarkable over the next few decades? There is also, of course, the possibility of further waves of migration from these poor countries into the richer countries in America, Europe and Asia.

But the political, social and economic problems caused by mass migration are so severe, that the only viable alternative would be to take capital and management to the workers in these poor countries, rather than having them migrate to the rich countries. We shall argue that while such a new direc...

Ironically, very few use a line of argument that we do believe is a potent and immediate roadblock, but one that will have to be dealt with in one way or another—the debt trap and how to get out of it (Chapters 11 and 12 respectively). The deflationary bias over recent decades, reinforced by the Global Financial Crisis (GFC), has led to massively expansionary monetary policies, with interest rates, both nominal and real, coming down to historically exceptionally low levels. This has, as was intended, led to a dramatic increase in debt ratios, both in the public and private sectors. The main exception in recent years has been the reduction in the leverage ratios ...