Grappling With An Inescapable Drag On Economic Growth

by Gene D. Balas

Much has been said about the weak GDP growth in this economic recovery, but it’s not limited to just the U.S., it’s a feature in Europe and in Japan, especially, where low growth has long been entrenched. Reversing low growth has defied policy prescriptions or even massive monetary stimulus; otherwise, Japan would have been growing remarkably by now.

Not surprisingly, aging populations are commonalities to each of these regions, and demographic changes are indeed what explain much of the drag on economic growth.

How much of an economic drag comes from demographic changes?

In solving this puzzle, researchers at the Federal Reserve created a complex quantitative model to examine the factors at work, and described their results in a paper released earlier this month, Understanding the New Normal: The Role of Demographics. They determined that the bulge of baby boomers moving through their life cycle both created the economic boom of decades past and is now contributing to the current slower pace of growth.

In fact, the researchers determined that these demographic forces reduced the rate of real GDP growth by 1 ¼ percentage points annually, from what it had been historically. Remember that the long term potential growth rate of the economy is determined by two basic ingredients:

• how many people are working and

• how much each of them produces with the help of equipment and technology.

Or, in other words, potential GDP growth is simply the sum of the growth of the labor force plus productivity gains. If the labor force is growing slowly and if productivity gains are now weak (perhaps the big gains from new technologies have already left their mark for the moment), then it will be very difficult for the economy to expand at the same rate it had in the past. Given trends in the growth of the labor force and recent estimates of productivity gains, the long term potential growth rate of the economy is about 2% or so, which is also roughly in line with the Fed’s estimates.

It’s not just that Baby Boomers are getting older

In addition to the factors above, there are a few other considerations, too. If the population is aging, it is because previous generations, including the Baby Boomers, had fewer children. That freed up both would-be parents to enter or remain in the workforce, as maternity leaves, for example, would no longer be as necessary. And with fewer dependents and both would-be parents working, relatively more funds could be spent on discretionary goods rather than basics like food and clothing. This fueled the consumption boom of the 1980s and 1990s as the Baby Boomers entered the peak of their careers and spending patterns. Importantly, that also allowed the savings rate to be high during the 1980s and into the 1990s, bolstering returns across asset classes as funds were invested.

Now that process is ending as retirement looms and investments are transitioned from stocks and into bonds and then, ultimately, spent during retirement. The researchers determined that, “in the case of real interest rates, we find that falling fertility rates and increased employment rates in the 1960s and 1970s have each contributed ½ percentage point to the decline in the equilibrium real rate between 1980 and the present, with longer life expectancies accounting for the residual.” That sums up to a 1 ¼ percent reduction in real interest rates.

Looking at it another way, one can see three demographic components impacting lower interest rates in some way:

• Baby Boomers, in earlier years, increased savings in preparation for retirement, thereby driving down interest rates.

• Baby Boomers are now starting to allocate from stocks into bonds during retirement.

• Baby Boomers are reducing spending in tandem with retirement (and impacting economic growth as well as interest rates).

The role of productivity

Another factor, too, is the productive capacity that was built up to support a consumption engine that is no longer running at full tilt. Companies have more equipment and infrastructure than they are currently using, and with unused capacity, there is little reason to invest in new equipment or technologies. This helps explain the weak rate of capital spending in GDP – and may also help answer the vexing question of why productivity gains are so anemic. After all, productivity might be enhanced by innovation, which requires research and investment.

No quick fix

The conclusion the researchers reached was a bit dour, observing that these conditions may represent a “new normal” environment of slower economic growth. It is exceedingly difficult to overcome the enormous challenges of demographic headwinds and the vexing dilemma of missing productivity gains in any easy sort of way, making the job of policymakers that much more difficult. It is not an issue, after all, that can be resolved through simple policy prescriptions, no matter how much we may all wish it to be so.

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