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

by Charles Goodhart

The integration of China into the global manufacturing complex by itself more than doubled the available labour supply for the production of tradeable products among the advanced economies (AEs).

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.

workers migrated aggressively from rural to urban China—the latter’s share of total population increased by over 23 percentage points (pp hereafter), or 370 million between 2000 and 2017. In the USA meanwhile, the participation rate (share of labour force to population) declined by over 4pp during the same time—had

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%.

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.

During the period 1970–2010, the decline in the number of young relative to the working force outweighed the rise in the number of retirees (Table 1.1), except in Japan and the UK.

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.

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.

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.

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. For this bleak outlook, they largely blame globalisation and competition from abroad, including the offshoring of manufacturing production, competition from immigrants taking up unskilled jobs in their own countries, and the failure of the elite to respond to their concerns. The result has been a rise in political populism and a crisis of economic liberalism. 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.

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.

If tax rates should have to rise significantly to finance pensions and medical expenses , will workers start to bargain for post-tax real wages?

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.

In net terms, we believe savings are likely to fall by more than investment, lowering the real interest rate.

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.

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.

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 rate of growth of real GDP, with the implication that the tax burden arising from pensions will rise in line with the ratio of aged to the total population. 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 electorate will provide a potent constituency for keeping pensions rising in line with real output.

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.

More generally we argue that the huge positive labour supply shock to the global economy has made labour so weak that their bargaining power has been significantly reduced. This has meant that the level of unemployment at which inflation starts to accelerate has probably declined quite sharply by several percentage points. To use a technical term, the non-accelerating inflation rate of unemployment (NAIRU) has gone down significantly. For example, the proportionate membership of trade unions in the private sector has declined sharply in most countries. But as labour becomes scarce again, it will recover its mojo. How quickly and how sharply this reversal may occur is yet to become clear.

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.

There are, of course, several mitigants to our view that the reversal of demographic factors will shift global trends from deflation to inflation over the next thirty years. We have already mentioned two of these, which are included in Chapter 10, notably the possibility of a considerable further rise in retirement ages, and the possibility that the relative generosity of state pensions will decline in future, in order to limit an otherwise rise in tax burden. But in that same chapter we discuss another possible mitigant, which is that, rather than reversing, globalisation could take another turn. 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.

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

Although debt ratios have risen dramatically, there is not enough concern about leverage. That’s because debt service ratios have not risen along with debt ratios, thanks to an almost exact inverse correlation between rising debt ratios and declining interest rates.

At the same time, these low interest rates have, naturally, enhanced asset prices. Sometimes the monetary policies of Central Banks have been accused of exacerbating inequality. But if Central Banks had not expanded, other policies being held constant, unemployment would have been worse, which normally hurts the poorest most. So Central Bank policies have, on balance, probably reduced income inequality. The alternative policies that some suggest would have been greater reliance on expansionary fiscal policies. But not only have public sector debt ratios grown faster over recent decades than in any other previous peacetime period, but also the outlook for expenditures relating to health and pensions is such that projections of future budgetary conditions are worrying, to say the least,

And, if we are right, future inflationary pressures will drive up interest rates, adding yet further to fiscal problems. 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.

The inevitable question then is, how do we escape this debt trap? In Chapter 12, we discuss a variety of mechanisms for escaping the debt trap, notably growth, unexpected inflation, default, jubilee debt cancellation, debt restructuring or a shift away from debt finance towards equity finance. We demonstrate that all these alternatives have problems, except for growth, which, alas, is likely to remain sluggish at best. Of course, what would be nice would be to raise productivity, but its growth has been disappointingly weak during the period since the GFC, for reasons that remain unclear.

As the Ministers of Finance have presided over continuing deficits and rising debt ratios, the interest burden has been held down by simultaneous falls in interest rates. Central Bank policy has eased the path for politicians. No wonder that Central Bank independence has not been subject to much serious criticism, except in relation to their more unconventional monetary policies, which have seemed to blur the boundaries between monetary and fiscal policies.

owners. If we are right in our thesis, then much of the disinflation of the prior decades should be attributed to demographics, putting the efficacy of monetary policy in dictating the path of inflation into even greater question than it has been in the post-crisis period.

Moreover, the effect of quantitative easing (QE) has been drastically to shorten the average duration of public sector debt (including the cash liabilities of the Central Bank). The implication of this is that when interest rates go up, this will have an even quicker effect in raising the interest burden that the Minister of Finance has to face. So, Chapter 13 argues that Central Bank independence (CBI) will come under even greater threat in the future than it has been recently.

Did globalisation lead to the ascent of China or did China’s rise lead to globalisation? It is not an easy question, and the turn in the fortunes of both over the last half a decade will not make it easier to answer either.

The ratio of China’s population to the world’s has actually fallen since 1955. Thus, it is not the relative size of China’s population, but the accelerated rate at which its labour force integrated into the global economy that has mattered.

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.

It was in the second phase that privatisation of SOEs began, when small, medium and even some large SOEs were closed or sold to the private sector. The private sector showed dramatic growth in this period, but large SOEs remained monopolies in sectors considered to be key to national interests (including banking).

China became a WTO member after 14 years of negotiations. Its accession was granted conditional upon a long list of liberalisation and opening-up measures (set mostly by the US) to allow greater access to, and see greater transparency in, China’s markets. China was, in broad terms, required to: Lower its tariffs to under 10% within five years and reduce tariffs on some agricultural imports almost to zero. The reduction or elimination of non-tariff barriers. The opening up of some key sectors including telecommunication and banking. Protecting global intellectual property rights.

Towards the end of that decade, there were clear signs that China’s reforms were losing steam. Growth had fallen every year for most of the 1990s from a very high level, inventory accumulation had risen to worrisome levels and the inefficiency of SOEs was an open topic of discussion. In 1999, four large asset management companies (in effect, so-called bad banks) were set up to take on the large quantum of non-performing loans from the banking sector. Ma and Fung (BIS 2002) estimate that the total size of the non-performing loan problem at the four big state-owned banks could have ‘amounted to RMB 3.4 trillion (USD 410 billion) or around 42% of the big four banks’ loans outstanding at the end of 2001.

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.

In a nutshell, China benefitted asymmetrically from WTO inclusion. Its entry on an MFN basis to the US market around the same time led to a decline in manufacturing employment there at a rate that had not been seen in previous decades.

The third event was China’s response to the Great Financial Crisis. China’s aggressive response to the onset of the Great Financial Crisis was a major factor in preventing the collapse of the global economy. Diagram 2.3 shows that China’s credit growth in the aftermath of the crisis rose by 35%.

The year 2012, however, marked the beginning of the end of China’s demographic contribution to the world. Unsustainable credit growth is usually seen as borrowing from the future.

Over 2014–2015, China’s manufacturing and property sectors saw a major slowdown. Along with the coincident slowdown in emerging markets and global manufacturing, China’s slowdown contributed to the dramatic fall in oil prices from nearly $150 a barrel to $27 in 2015 and a collapse in global trade.

China’s growth strategy for many decades was designed to direct domestic and global resources to accelerate manufacturing and investment. Its basic advantage was its massive and heavily underutilised supply of labour, a lot of which had resided in its interior, rural regions.

A key difference between AEs and EMEs is that capital is cheap and labour is expensive in the AEs while the opposite is usually true in the EMEs. In order to accumulate capital rapidly, the cost of capital has to either fall, or be intentionally distorted. In the earlier stage of China’s growth strategy, monetary policy was designed to dramatically lower the cost of capital. During this phase, it was the state players that were the tip of the spear even though the private sector grew rapidly. SOEs, state banks, and modern, state-directed industrial policy were all an integral part of China’s growth strategy during its ascent.

China’s ‘Hokou’ registration system allowed this migration to occur without too much of a burden on the urbanising areas. The Hokou system essentially provides a passport for urban citizens. Migrants without credentials can reside in urban areas for work but they do not have access to most urban services including health care and education. As a result, the cost of migration does not pass on to the administration of these urban centres. It has resulted in only the workers themselves moving in search of work while families stayed in the rural habitat where they can access their local services. Without the Hokou system, rural workers might have sold their land and moved at a much faster pace to the urban areas, resulting in a significant excess supply of urban labour and, perhaps, of rural land as well.

The multi-decade, global decline in nominal and real interest rates has already been documented. The domestic cost of capital was lowered through three mechanisms.

First, China dealt with the ‘impossible trinity’ by imposing strict capital controls, allowing the exchange rate to be fixed and domestic monetary policy to be independent of global monetary conditions. The ‘impossible trinity’ dictates that an economy has to choose two out of the trio of free capital flows, a fixed exchange rate and monetary independence—having all three is not possible.