'Alice in Wonderland' Economic Policies Overlook the Demographic Challenge Ahead

13 Apr 2015 | Giada Vercelli


The world’s oldest person, who celebrated her 117th birthday a month ago, died last week on Wednesday in Osaka, Japan. Born in 1898, Mrs Misao Okawa was recognised by the Guinness Book of World Records in 2013 as the world’s eldest. Undoubtedly, Mrs Okawa was a coriaceous lady, given her endurance of several wars and major natural disasters. Nevertheless, her achievement may be downplayed in a few years: living until 100 and beyond will become the norm for children born within the next generation, according to estimates published by the UK Office for National Statistics. The average life expectancy for new born girls in the UK is to reach 97 years within two decades and the life expectancy for women will reach the unconceivable milestone of 100 in 2057. We’ll all live happily ever after, and for many years to come. Or not. What are the social, economic and political implications of our much aspired longevity? And are the policymakers and the financial industry ready for the challenges set by a collective prolonged existence?

Some economists have claimed that today’s zero inflation rate has little significance for the economy, claiming that even if low negative inflation can matter if it reinforces low wages, there is little sign of this phenomenon in the UK. However, when mixed with weak growth and high debt levels, deflationary risks should be a matter of discussion for economic policy after May’s general election. “In the UK we live in a new paradigm,” Paul Hodges, Chairman of IeC and an expert in the economic impact of demographics, explains in a conversation with Euromoney Conferences. “While life expectancy at the age of 65 has gone up by two thirds, fertility rates have collapsed, reduced from the 1960s peak of 2.8 babies/woman to just 1.7 babies/woman 40 years later. For the first time in history we have a completely new set of population dynamics. It will be quite impossible to get the kind of economic growth we had at the time of the baby boom, as consumption now is 64 per cent of the UK’s GDP, according to World Bank figures (http://data.worldbank.org/indicator/NE.CON.PETC.ZS). The majority of UK households has been headed by someone aged over 50 since 2002 and as a result of that the average household expenditure has been in steady decline since 2006, according to the family spending index of the UK Office for National Statistics ( http://www.ons.gov.uk/ons/rel/family-spending/family-spending/index.html).”

The current lack of aggregate demand stems from policy choice to finance debt burdens rather than resolve them, as Dr Paul Mills, the former Head of the IMF’s London office put it in a lecture on debt levels and changing demography at the beginning of this year: “Macroeconomists tend to dismiss aggregate leverage measures, but what really matters is the distribution of debt relative to assets, and the ease of refinancing. Net debt burdens are concentrated on sectors with high marginal propensities to spend such as young households, growing companies, and governments. Hence, keeping debt burdens elevated reduces the likelihood of strong demand recovery.”

Discussions about the economy have so far delivered ‘Alice in Wonderland policies’ according to Paul Hodges, “because there is no grounding for them in the demographic changes that we are now experiencing. This is creating a shift of historic proportions. But instead of tackling the core issue, policy makers have chosen to use monetary policy to treat its symptoms, via the creation of temporary wealth effects in housing and financial markets. The end-result has been to build up further headwinds for future spending by younger households. These will now have to repay the debt created by quantitative easing and jumbo mortgages. An honest discussion about demography and the economy would be desirable during the electoral campaign”.

A debt-based financial system costs little to establish and to operate and is easy to be carried on from one government to the other. However, falling prices also cause debt to rise over time, as shown by the binge-borrowing many western economies have recently experienced. Dr Mills has warned that “the absence of contractual price mechanisms to adjust debt claims to debtor servicing ability or asset values leaves systems fragile when shocked. The inherent fragility of debt-based intermediaries, i.e. banks, forces policy makers into bailouts and fiscal stimulus rather than risk collapse of the payments infrastructure.” The dilemma is whether to keep debt burdens financed at ever lower rates or write-off debts. “One thing we know is that we are going to be unable to repay the debt that the government and the Bank of England have incurred in their futile attempt to return us to a supersized level of growth,” Hodges echoes. We don’t have enough people in the key spending group of 25-54 years of age that can do the heavy lifting for the economy. The money will run out.”

In the US, senior economic adviser William Emmons and policy analyst Bryan Noeth agree that the method economists typically use to measure the financial health of the middle class fails to reflect important shifts in demography.The Federal Reserve Bank of St. Louis,  found that economic inequality is actually much worse if you take into account the demographics of the middle class.

One of the unintended consequences of the extraordinary monetary stimulus that is still in place after seven years since the financial crisis has started, are the elevated valuations of asset. But should a normalisation of monetary policy happen, would debt levels be sustainable? If this is not the case, confidence will be hard to rebuild regardless of the amount of liquidity that gets injected into the economy.

This also worsens the problems of the underfunding of defined-benefit pension schemes, Dr Mills has highlighted in his analysis. When in 1902 George Barnes formed the National Committee of Organised Labour on Old Age Pensions, David Lloyd George had to raise government revenues by an additional £16 million a year to pay for these pensions, including increases in taxation. At the time there were five hundred thousand people over 70 years old who were entitled to receive pension benefits out of 40 odd million people in the UK. Today, the pension age is lower and it is a universal benefit with about 17 percent of the population getting it ( https://www.gov.uk/government/news/pensioners-change-the-face-of-britain-over-the-queen-s-reign). This is increasingly unsustainable. Immigration can help if the immigrants are highly educated people; otherwise new immigrants need extra support, a further burden on UK finances.”

Where there is a collapse of trust in the political will to tackle long term economic strategies, which usually don’t deliver results in time for the next round of elections, the financial services industry may need to step in to adjust the imbalances. The pension fund industry is very well positioned, given that their membership will find themselves deprived of government financial support. “Pension funds need to stand back from the idea that they need to be profitable on a quarterly basis,” warns Hodges. “The oil price is a very good example. When pension funds invested in oil, they made some money, but what they actually achieved was to push energy prices up for our pensioners. On a net basis, they made a small one off gain, but the spending power of each of their members decreased.”

The other element that would be desirable is for the pension fund industry to lead the companies they are investing in, to develop products and services for this generation of pensioners. There is virtually nothing for a vast number of older people. By providing goods tailored for the older generation, companies would not only improve quality of life for their customers and generate profits for their shareholders, but also create long term investment. “CEOs ready to rise to the demographic challenge should focus on five key areas: health, shelter, mobility, food, water. For instance, automotive companies are producing cars in great numbers for a social landscape that no longer exists: less people will commute from and to suburbia, as an increasing number of older people are moving to urban centres. It would be time to invest in a ‘pay-to-play’ business model, charging for the actual use of services and goods.”

The 117-year old Mrs Okawa has not lived long enough to see if Abenomics actually works, but our political leadership has plenty of time to learn lessons from Japan. Japan has the highest level of government debt per person at a hundred thousand dollars per person, according to Bloomberg data ( www.bloomberg.com/visual-data/best-and-worst//most-government-debt-per-person-countries). This means that every resident of Japan owes almost 100,000 dollars to the country's creditors and it is unlikely to be repaid. In addition they struggled with deflation, caused by supply left over from the past without the demand to support it. Deflation neutralises monetary weapons against weak demand. There are practical limits to how far policy rates can fall.


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