By Claus Vistesen, on November 23rd, 2010
I don’t suspect anyone remember part 1 of this series so if you want to refresh your memory, you can have a look here. In that note, I treated some of the more theoretical issues in the form of how demographics might affect long run growth as well as open economy dynamics. In particular, I discussed the broad tenets of the life cycle framework and how it relates to savings and investment behavior as a function of ageing. In particular, I discussed where I think there was room for improvement and further study.
So, in this one I would that I would look at an all together more practical topic in the form of asset demand and prices as a function of demographics. Again, this is a substantial area in the finance and macroeconomic literature and I will not give a detailed literary review here. Besides, if you want to move straight to investment and portfolio implications this piece by Alicia Damley and this piece by Ed Dolan are really spot on in terms of what you need to think about. Basically, you want to buy the young guns and sell the old farts and the key to obtaining this insight is to remove the focus from population size to population structure (age structure). I have been harping about this since this blog’s inception 5 years ago, I am doing a PhD about it, so it is with pleasure that I see the discourse hitting the tapes of Seeking Alpha which indicates that it is grabbing hold of other people than those stuck in the university ivory tower.
In this sense, this is hardly a new story . Emerging markets represent the main investment story in a post Lehman context. Everyone wants to buy India, China (although she is quite different), and Brazil and as a result of a myriad of ETFs and other types of market trackers, you don’t need to know your way around the streets of Bangalore to gain exposure to the Indian growth story.
This is a turkey shoot then. And I largely agree with the main thrust of the argument.
The real maturing of the emerging world which began some 10-12 years ago and which will continue for the next decades is undeniably a force of good for savers and investors and the real question is whether it is too good, and thus whether there will end up being too much capital chasing too little yield. In order to understand this link, you would need the second part of the equation (see part 1) and understand how demographics affect capital flows and the transfer of savings between economies as a function of demographics.
In this note I will talk about the idea of a life course but in the way that it is traditionally narrated. As such, the life course is a sociological theory which describes phases of life and in this sense it is more topical than the idea of a life cycle which only describes the flow of investment and savings. Indeed, in finance and economics you only hear about the life cycle even if scholars who investigate for example the dynamics of house prices as a function of demographics essentially are deploying a life course framework.
What is the Life Course then?
Well, Wikipedia does a good job of explaining it for the layman and this small snippet also captures the essence quite well especially
In particular, it [Life Course Theory] directs attention to the powerful connection between individual lives and the historical and socioeconomic context in which these lives unfold. As a concept, a life course is defined as “a sequence of socially defined events and roles that the individual enacts over time” (Giele and Elder 1998, p. 22). These events and roles do not necessarily proceed in a given sequence, but rather constitute the sum total of the person’s actual experience. Thus the concept of life course implies age-differentiated social phenomena distinct from uniform life-cycle stages and the life span.
The only mental leap you need to perform here is to replace socially defined events with economically defined events and you have yourself a working model. Now, if the finance geeks out there think that I am turning soft and if the sociologists believe that I am reducing their complicated theory of human lives into numbers and equations, both groups have my symaphaties.
Yet, this is a part of my master plan to elevate ageing and the change in age structure to the ultimate unit of analysis on a macroeconomic level. And in order to do this, we need more than merely the life cycle or the life course. We need them both. In fact, only by fusing the two will be able to develop a framework which is rich enough to deal with the complexities of ageing and macroeconomics. Indeed, I am betting a good deal of my academic oevure on this.
Consequently, if a socially defined event of interest to a sociologist or demographer might be the age of marriage, age of first child birth, age of first encounter with alcohol, age of sexual debut etc, then an economically defined event be something along the lines of age of maxmimum borrowing relative to asset value, age of purchase of first home, purchase of durables as a function of age as well as of course, the main topic in the financial literature as it currently stands; portfolio choice as a function of age (stocks and bonds basically, but you can vary the portfolio here as much as you like, at least in principle).
So, this inclusion of life course into the general thinking of macroeconomics is crucial and even though economists always talk about the life cycle, they are often implicitly assuming a life course perspective.
In the end, I will keep it short here.
There is a myriad of sources on aging and asset prices and demand in general. The main man in the world of economics and finance is James Poterba from MIT (just check list of papers) and I would emphasize in particular the strand of literature that deals with housing and demographics (I have a paper coming here).
By Claus Vistesen, on October 20th, 2010
With the Fed/QE singularity still dominating the markets I thought it would be time for an academic digression since I am sure you don’t need me to point you to sources on the current market climate (especially not in earnings spam week).
The one is a real treat and essentially is a literature review of how endogenous growth theory has incorporated the issue of population ageing into growth in the long run. It is written by Klaus Prettner and Alexia Prskawet and is out of the Vienna Institute of Demography which is one of the top 3 (in my opinion) constellations that produce material on the link between demographics and macroeconomics.
The purpose of this article is to identify the role of population size, population growth and population aging in models of endogenous economic growth. While in exogenous growth models demographic variables are linked to economic prosperity mainly via the population size, the structure of the workforce, and the capital intensity of workers, endogenous growth models and their successors also allow for interrelationships between demography and technological change. However, most of the existing literature considers only the interrelationships based on population size and its growth rate and does not explicitly account for population aging. The aim of this paper is (a) to review the role of population size and population growth in the most commonly used economic growth models (with a focus on endogenous economic growth models), (b) discuss models that also allow for population ageing, and (c) sketch out the policy implications of the most commonly used endogenous growth models and compare them to each other.
As you migth remember I started a blog series some time ago on macroeconomics and demographics and in the first post (second is coming soon on demographics and asset prices) I basically laid out some picture points in the context of life cycle theory and demographics. One of these topics included growth which in itself is illusive but also a topic which almost deserves its own label outside traditional macroeconomics since it is a field which is so vast yet pretty strict in methodological terms. The paper by messieurs Prettner and Prskawet is a very good re-cap of the literature (I am definitely going to read 5-6 papers on their ref list) and brings you up to date on how growth theorists model the effect of population ageing on growth in the long run.
The general conclusion is, contrary to the classical Solow model, that population dynamism is positively related to growth or that population ageing is a drag on growth in the illusive steady state. This comes with some qualifiers of course, but as I read the evidence it is pretty much overwhelming from the models we already have. This is an intuitive result, but also a big one in relation to growth theory where the incorporation population ageing has been very long time underway. Moreover, since the contributions who stipulate this are only from the second half of the first decade of the 21st century I think we can call this an advance of no small nature!
So far so good then.
However, apart from the strides made in the context of growth theory I also asked the question of whether steady state growth theory, in general, was suited to explain the phenomena we really would like to explain. Specifically, I said …
The basic problem here though remains the concept of the steady state which means that we must construct model such as to allow the change of capital through time (or its derivative with time) to be 0 in the long run. Note here that this condition is not imposed on the basis of empirical behaviour but on the basis of (mathematical) analytical tractability. So, apart from the uncertainty surrounding exactly what this ”long run” is, it also locks in the analysis and assumes away a large part of the important aspects of even basic life cycle behavior. Specifically, the idea that once reaching a steady state any change in the savings/consumption rate will one have transitory effect and that the economy will automatically (and always) converge to the same growth rate/state as before is a problem. Essentially, the whole idea of a steady state whether be it in the form of an exogenous or endogenous growth theory framework is a huge problem since it is evident that such a thing does not exist. And even if we could establish over a very long run horizon that such an average/constant path is a good approximation we would be ironing out all the interesting and important questions in the process.
Consider for example the model presented in Gruescu (2007) (see list of references in the paper [1]) and the prediction that growth in the long run is a negative function of a growing dependency ratio. This seems logical and intuitive but this also becomes a problem as Prettner and Prskawet rightly points out since we can’t really assume that the dependency ratio grows in the steady state since what happens when it becomes 1 (its natural limit?). As it happens, the idea of a growing dependency ratio in the long run and indeed a growing drag from ageing is exactly the right assumption in most OECD economies. Thus, for all intent and purposes what constitutes the long run for them is equal to a growing share of the elderly in the population.
But the problem is more fundamental since we are reducing a dynamic and path dependent parameter (ageing) to a growing constant in steady state in which growth itself is constant as a function of a some form of technological growth rate (in this case exogenous, but it need not be). Indeed, I think it fair to say that this is an onthological issue that we have not yet adequately addressed or which has not yet been duly formulated. My point is simple; in order for something to be important in the steady state, it must be exhibit a constant and stable growth rate. Demographics and the effect it exerts on economic processes are neither constant nor stable (although again, the idea of a constantly growing dependency ratio is not that far fetched).
But I digress.
The frontline in growth theory has come a long way in explaining the association between long run growth and demographics and while, as the authors point, out much depends on the modelling framework and thus the underlying assumptions on how relevant inputs to growth are created and transformed into output I think (and hope) that empirical observation and falsification will determine which frameworks that end up as the best models to explain growth.
One thing is sure, the paper by Prettner and Prskawet is a great tour of the most important models and their implications. If you are doing any kind of work on this, you want to read it.
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[1] – Basically, Gruescu (2007) explores a classicl Solow model and augments it with population aging. I have not gone through the model, but it looks pretty neat. So it is a good place to start.
By Winton Bates, on September 30th, 2010
I ended my last post suggesting that it is absurd to provide pensions that are not subject to means tests because this involves taxing people of working age more heavily in order to add unnecessarily to the incomes of wealthy retirees. This raised the question of whether the elderly poor are likely to fare better in the context of the looming pensions crisis in OECD countries under means tested pensions or universal benefits.
This question is most relevant in countries that have not already adopted some form of pay-as-you-go universal aged pensions. Path dependency is involved. Once a country goes down the universal pensions path there are substantial political difficulties in back-tracking because this system encourages each generation of retirees to expect rewards for the taxes they have paid to support the preceding generations of retirees.
I expect that the political economy of how the elderly poor are likely to fare under alternative systems has been researched previously, but I haven’t yet found any papers that are directly relevant. So I will attempt to sketch out some preliminary ideas, based heavily on Australian experience.
One factor that will influence how the elderly poor fare under alternative pension arrangements will be their own political power as a group. This seems to vary greatly between countries depending on such factors as their use of voting rights. The presence or absence of means-testing could make an additional difference to the political power of this group since it identifies pensioners as a particular group of elderly people who have a common interest in lobbying for higher pensions. In that respect, means testing causes the interests of the elderly poor to differ from those of other elderly people.
Pension levels of the elderly poor are also likely to be influenced by the way the political objectives of other elderly people (and of middle-aged people who are planning for retirement) evolve under different systems. Peter Lindert’s analysis of the political economy of the public pension crisis seems to provide a good starting point to consider this. He summarises as follows:
‘At first, up to the 1980s, the rise of the elderly population gave the elderly more political clout in the industrialized OECD countries. The rise in their political strength was one reason why the relative generosity of pensions rose and budgets switched from fully funded pension systems to pay-as-you-go systems, giving one lucky generation higher pensions paid for in part by the younger generation. By the 1980s, the pressure on government budgets had become acute.
From that point on, the further rise in the elderly share of population began to undermine their political strength. True, pension budgets are not declining and are projected to rise a bit more as a share of GDP. Yet, the level of pension support per elderly person is destined to go on dropping as a percentage of the average income of the whole population’ (‘Growing Public’, Vol. 1: 208).
As the number of retirees rises relative to numbers of people in the workforce, their interests are increasingly aligned with those of the community at large in maintaining incentives for the goose to continue laying golden eggs. If excessive demands by retirees result in higher tax rates the adverse consequences for economic growth will be reflected back in their future pension levels.
The demographic transition stemming from lower birth rates and increased longevity is far more advanced in some countries (e.g. Sweden) than in others (e.g. Australia). Signs that the increase in the elderly share of the population may be beginning to undermine their political strength are only now beginning to appear in Australia, with a foreshadowed increase in the age of eligibility for pensions.
Australian experience suggests that when the aging middle classes have political clout they can exercise it to look after their own interests despite means tests for aged pensions. The relaxation of means tests, combined with tax concessions to encourage investment in private superannuation, has resulted in total government support for retirees being remarkably similar across a wide range of income levels (shown here). This suggests that total government support for retirees would be much the same under a flat rate universal system without incentives for private superannuation. Complicating matters further, however, the government has allowed people to access tax-privileged superannuation funds in lump sums prior to pension age. This has provided an added incentive for people to retire early, splurging lump sums and living off accumulated wealth until they become eligible for the aged pension.
As the increase in proportion of elderly people in the population in Australia reduces the per voter political power of this group, I would expect the per voter political power of the elderly poor to diminish to a smaller extent than that of the much larger group who hope to benefit from the private superannuation tax and pension means test rorts. I expect incentives for early retirement implicit in the superannuation arrangements will be an early casualty as attempts are made to contain government spending on retirees. If a choice has to be made at some time in the future between, say, maintaining the current level of the aged pension in real terms and maintaining superannuation tax concessions, I expect that maintaining the aged pension levels would be likely to win the political debate. Similarly, given a decline in grey power on a per voter basis I doubt whether superannuation tax concession would win the political debate if a choice has to be made at some time in the future between maintaining these tax concessions and an overall lowering in income tax rates to promote economic growth.
I suspect that the elderly poor would be less able to protect their interests under a universal pension because the support arrangements would not enable them to distinguish themselves as a group whose economic interests differ from those of other elderly people.
By Claus Vistesen, on September 8th, 2010
The financial and economic discourse is a funny beast really; it can, if harnessed properly, shed light on future investor and market performance, it can give a diversified and detailed picture of any given economic or financial topic, and it is a place where stories, no matter how counterintuitive and misplaced, can linger and grow for a long time.
I am focusing on the last aspect and in doing so moving in alongside Edward (here, here and here) as well as Wolfgang Munchau in pondering just why it is that people are so excited about the fact that Germany continues to experience stellar growth rates largely driven by exports. Moreover, in his latest piece, Edward once again opens up the discussion for just what it is that we are supposed to do with those global imbalances and it is here that I will also spend my time.
Of course, just what it is that is misplaced here is definitely a matter of opinion and not everyone seems to be content with neither Munchau’s point (comments section) nor Edward’s take on the situation. Not surprisingly, I will come out in favor of Edward’s take here but I do so arguing on the basis of fact and not on the basis of some inherent hate towards Germany, Spain or any other of European economy for that matter. I would hope that this, at least, is clear for all to see.
The Problem
The fact that Germany does well is not the issue here (indeed, in isolation this unequivocally good news), but the fact that Germany is still driven by exports and the fact that Southern Europe continue to languish in uncompetitiveness tells a cautionary tale that some of the most important prerequisites for a sustainable trajectory of the global economy have not been met. So, while Edward opted to tell the same story with a chart, I will do so in words.
Before the financial crisis, the world was characterised by structural surpluses in Japan, Germany and the rest of Asia [1] to match a growing US/Anglo Saxon current account deficit. Europe as a whole was running an overall balanced current account which, however, masked notable intra-European imbalances between Southern and Eastern Europe (with external deficits) and Germany as the main supplier of credit to this expansion[2]. So, before the crisis we had export dependent Germany and Japan coupled with USD peggers in Asia (where China will soon become export dependent herself) to match current account deficits in the US/Anglo Saxon world and Eastern/Southern Europe.
This system was clearly unsustainable, but it worked as long as it did especially because of the US economy’s remarkable resilience despite the huge load put on its shoulders offering capacity to the credit supplied by the surplus nations. The system however famously buckled as a result of the subprime mortgage debacle which had its origins, ironically enough, exactly, in the mortgage debt binge made possible by the flow of cheap credit to the US economy.
As a result (and most economists would agree here I think), the recovery that had to follow the crisis was closely tied to a resolve of global imbalances. Yet, the recent narration of the German economic performance on account of its strong export performance shows us that we have not really gotten anywhere.
This brings us to the problem.
Leading up the crisis, the global economy was populated by two outright export dependent economies in the form of Germany and Japan as well as a batch of USD peggers in form of China et al and the petro exporters. Today, as we all hope to muster some form of recovery we are in a situation where not only Japan, Germany and China rely on exports to power their economies so must now the US and, in effect, Europe as a whole since there is no more juice left in either Southern, Eastern or, for that matter, Anglo-Saxon Europe to run respectable current account deficits. Indeed, the continuing talk about how this and that country is now going to rely more on exports or is about to become an export powerhouse strikes me as extremely odd since no one seems to be asking the real question of who exactly are to run the corresponding deficits?
Economists trained in the art of general equilibrium would immediately point out that it does not matter much since if there is one thing that we can be sure off it is that at all points in time the sum of external deficits will equal the sum of external surpluses. I cannot but agree, but this also means that speaking of surplus nations as the good guys and deficit nations as the bad guys does not make sense. What we really need here is economies with ability to run sustainable external deficits; this basically means economies who need to borrow to maintain trend economic growth and a proper rate of investment given the intrinsic return of the economies investment pool. As such, if we look at the structural forces at play there is not so much that we can do in the near term about a number of key issues.
- There is nothing that we can do about the great demographic shift and the fact that we are all rapidly ageing and soon will hit the threshold where we effectively become dependent on external demand in order to achieve economic growth, pay pensions, build roads etc. Germany and Japan shows us where we are headed and while timing will differ markedly it is towards their current structural setup the entire OECD is drifting
- The US and many of the other Anglo-Saxon economies have pretty sound demographics [3], but they have overspent and over -borrowed to the extent that demographics become secondary to the massive force of deleveraging. Consequently, and while the US economy should, theoretically, be capable of providing, in a sustainable manner, some excess demand through a current account deficit the amount of private sector and, now, public sector leveraging means that they are simply tapped out. In addition, deleveraging is a slow and structural process which will take a long time and also engender behavioural changes in US consumers. In short; we cannot rely on the US consumer anymore and actually; the US economy now needs to export more than she imports in order to turn the boat around.
Old Maids who won’t play Anymore
An integral part of any discussion of global imbalances has to involve a suggestion as to on whose shoulders rebalancing is supposed to occur. In this context, the debate has focused on intra G3 rebalancing as well as the need for China to loosen the peg towards the US dollar. On the former account I have called this a game of Old Maid since the real question was never which of these economies that could contribute to global rebalancing, but to whom they were going to sell their exports and thus how they would compete with each other for export market share.
Old Maid is a card game where the simple task is to avoid holding a given card (often the queen of spades) at the end. Even in the company of good friends however, holding Old Maid at the end is not fun. Often, you have to buy the drinks, drop a piece of clothes, or endure other travails. And as it turns out, the global FX market is not unlike this good old game of cards where the Old Maid is proxied by having a strong currency on whose shoulders the correction of global macroeconomic imbalances must invariably fall.
In this context and while nominal exchange rates is not the best proxy for export market share the G3 fx edifice has been characterised by change of baton between the G3 currencies in terms of who is holding Old Maid*.
So far in 2010 there has been two stories. Initially, the main focus was one of a sharp depreciation of the Euro as the sovereign debt woes of Southern Europe sent the single currency reeling. That trend reversed in a nasty short squeeze which saw the EUR/USD bounce very quickly from 1.18 to 1.30 (still down on the year). From here it seems as if the EUR/USD has resumed its old ways of trading on the risk on/risk off themes. The second story which has recently gotten a lot of traction is that of the ascend of the JPY especially in relation to the USD/JPY which has recently been very close to the lows of 1995. These two stories are captured in the chart above where the JPY has appreciated notably against the USD and the Euro while the Euro (against the USD) has weakened considerably since the beginning of 2010. Among other things, this has spawned an almost endless stream of commentary concerning the possibility for BOJ/MOF intervention in the currency market through direct purchases of the USD.
In so far as goes the idea of an old maid, Japan seems to be holding it in the first half of 2010 (against the Euro and the USD) while the USD holds it against the Euro. Curiously, and just as to ram home the real economics behind this strange metaphor, it is worthwhile emphasizing how it was precisely Japan’s economy that seems to have hit the breaks in H01-2010 while the European economy stormed ahead aided by a very strong Q2 performance in Germany.
Ultimately however, the idea of the Old Maid remains a trading theme with one important real economic implication. Whoever holds the Old Maid among the G3 currencies is losing market share relative to the two others vis-a-vis the emerging world and others willing or able to muster a respectable external deficit. The bottom line remains however that in the context of global rebalancing it cannot occur along the G3 axis (e.g. with German and Japan providing a boost through domestic demand). In short; these Old Maid cannot and will not play anymore
The Solution
I am not a big fan of one-off solutions and especially not when it comes to complicated problems like this. However, in relation to global currency alignments I think one big issue revolves around the need for big emerging markets such as e.g. India, Brazil and China to let their currencies go, as it were, simultaneously against the G3.
The chart above needs some explanation. First of all, 1999 = 100 and up means appreciation of the emerging market currency versus the g3 basket [4] and down means depreciation. As we can see, there has been no meaningful appreciation of big emerging market currencies vs the G3 when using 1999 as the benchmark (I use nominal exchange rates). This is exactly what has to change.
Surely, pushing those lines upwards would not solve the underlying problem in the G3 but it would address on very important obstacle to global rebalancing. In essence, it would put the burden on the broadest shoulders not because of some political/economic disdain for current account deficits in the OECD or because we should “exploit” the emerging world’s increasing aggregate demand, but simply because it is what makes economic sense. In this context, I have always agreed with the now silenced blogger Brad Setser that a global currency alignment is needed. What we have debated however was rather the importance attributed to China relative to other EMs as well as the importance of demographics as an underlying driver of the shift in aggregate demand growth and/or decline.
In conclusion there are two points to take away here. Firstly, the game of old maid will continue as a trading theme and as always you want to buy whoever gets to hold it among the G3. In addition, any currency moves in an intra G3 context also constitute shifting of market share vis-a-vis global high growth economies who will, whether it be kicking and screaming or willingly, be dragged into providing more of global aggregate demand through external deficits. For this to happen sustainably however, we need to see joint appreciation of emerging market currencies against the G3 or, more intuitively, the appreciation of a basket of emerging market currencies versus the G3. Continuing to believe that domestic demand can be a growth driver in the G3 let alone the OECD is the same thing as calling on Old Maids to play a game cards which they won’t and can’t play anymore.
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[1] – For simplicity, I will leave out pegging oil exporters here, but their role in this game is not fundamentally different.
[2] – Again, considerable complexity is left out. For example, the credit expansion in Hungary originated mainly from Switzerland (and by proxy through the Austrian banking system) and in the Baltics the Scandinavian economies supplied most of the credit (Sweden in particular).
[3] – Yes, I know the baby boomers will now become a drag and this is important but that is a bulge moving through an otherwise pretty stable population pyramid as a result of healthy immigration rates and replacement level fertility. In short; demographics in Japan are deflationary (and also in Germany), but I am not sure this is the case, strictu sensu, in the US.
[4] – This basket is created using share of global GDP of the G3 which is obviously inadequate, but let us just assume that we are dealing with economies that are either already relatively open or are going to become more open as we move forward (e.g. India).
* All data is from St. Louis Fed.
By Claus Vistesen, on August 17th, 2010
It has been a while since I have had a round of these and in the current macro/market environment I thought it an excellent occasion to take some pot-shots at the market discourse. So, read on if you want to see what it looks like when I am being (excessively) smug, an econometric model of Eurozone industrial production and a look at them US treasury yields which have gotten an awful lot of attention lately.
Don’t ya just love it when you are right?
Well I do and while this is not making a killer profit kind of right I still take comfort in the fact that the themes I am talking and thinking about also seem to be moving much closer to the center of the financial market discourse. First off, do you remember my notion of the Old Maid in the context of G3 currency markets?
Old Maid is a card game where the simple task is to avoid holding a given card (often the queen of spades) at the end. Even in the company of good friends however, holding Old Maid at the end is not fun. Often, you have to buy the drinks, drop a piece of clothes, or endure other travails. And as it turns out, the global FX market is not unlike this good old game of cards where the Old Maid is proxied by having a strong currency on whose shoulders the correction of global macroeconomic imbalances must invariably fall. In this way, and although one sometimes get the feeling that everyone believes that everybody may actually export their way out of their current misery, buying one country’s currency means selling another and thus, someone (be it an individual economy or a group/basket of economies) must end up holding Old Maid.
I hope the, albeit convoluted, introduction above will give you an idea of where I am going with this. Never mind of course that I was not entirely right in terms of which currency that would turn out Old Maid since I predicted the USD to strengthen (it has against the Euro) consistently in 2010 and while I believe this to come through eventually, the story so far has been a bit more complicated. First off, the USD did start 2010 holding Old Maid as tensions in the Eurozone saw the Euro plummet, but contrary to expectations, the remarkable strength of the JPY is becoming a story which cannot be ignored; in particular, its ill-recovered role as safe haven currency of choice in times of risk-off sentiment is something I did not expect.
To that end I feel vindicated in my overall theme and as such I welcome the Economist on my side of the fence as they articulate, this week, the idea of a race to the bottom among G3 currencies. I like the following in particular;
A cheap currency is especially prized now, when aggregate demand in the rich world is so scarce and exports to emerging markets seem the best hope of economic salvation. (…) The battle for a cheap currency may eventually cause transatlantic (and transpacific) tension: not everyone can push down their exchange rates at once. For now, though, the dollar holds the cheap-money prize.
Now, I am ready to repeat this almost to the degree of my readers potentially reaching insanity; the G3 are now effeftively dependent on exports to grow and since they are all looking to the same customers you end up with too much supply (of savings) relative to demand. Or … we can turn it around and say that there is too much demand for yield (excess supply of savings) relative to supply (capacity to absorb it). See, this is not so difficult.
The important part of course and where it all comes together is that this export dependency/propensity to save is not a deus ex macina but has a concrete and real driving force. In that vein, two recent contributions to the debate are very important. First off, we have Előd Takáts’ BIS paper on ageing and asset prices which provides evidence to show how ageing, in the context of real estate prices, are deflationary [1]. Now, I might take issue with the theoretical framework being a life cycle and not a life course model (wonk alert!) and I might also take issue with the empirical framework, but I wholeheartedly support the paper’s conclusion.
The estimates show that demographic factors affect real house prices significantly. Combining the results with UN population projections suggests that ageing will lower real house prices substantially over the next forty years. The headwind is around 80 basis points per annum in the United States and much stronger in Europe and Japan. Based on the analysis, global asset prices are likely to face substantial headwinds from ageing.
Note here his sample is only the OECD and thus global is somewhat a misnomer here.
Secondly, I welcome no other than almighty Goldman Sachs on my side of the fence (hat tip FT Alphaville) with their recent exposition on how global imbalances might not actually get better, but worse, and how all this is down to demographics.
Up to the age of 35, the population appears to be a drag on the current account position—in other words, people invest more than they save, on average. Between ages 35 and 69, people on average appear to save more than they invest. These are the so-called ‘prime savers’, and having more of them in the population would tend to improve the current account position …
In Alpha.Sources land this is a well known tune and while it may actually be a little more complicated than this I find it extraordinarily refreshing to be arguing alongside the Illuminati in the future. Now, I should make it immediately clear here that Goldman’s final conclusion is problematic;
These shifts could push towards a cleaner split between EM (mostly in surplus) and DM (mostly in deficit) than is the case in the current, more complex picture. In particular, demographic pressures could see the largest DM surplus countries (Japan and Germany) move into deficit and the largest EM deficit countries (Brazil, India and Turkey) move into surplus.
Well actually, they are just plain wrong here. Basically, they are scratching in the right places but end up with the wrong conclusions because they neglect the effect from ageing on aggregate demand. The argument above hinges on a link between dissaving and external deficits which is difficult to reconcile with rational economic behaviour. Finally though, and as a perspective I have only recently started to think about the role of (lagged) capital deepening in emerging markets is very, very significant as well.
What about that double-dip then?
So, Eurozone industrial production took a turn for the worse in June with the drop driven by weakness in durable consumer goods such as furniture and home appliances according to Bloomberg. To that end I thought that I would try to asses the potential for a double dip (in Europe) based on Alpha.Sources’ (only) proprietary econometric model.
I remain bearish on the macro environment in Europe and indeed I think that deflation will ultimately be a continent wide outcome, but timing is of the essence here. We learned today that Germany put in an all time excellent economic performance in Q2-10 which does indeed seem to be paving the way for a downward turn in H2 2010 (especially since my guess is much of this was driven by inventories). This view is somewhat supported by the evolution in industrial production which seems to be signalling a turning point in the annual change. This is consistent with mean reversion of the index in annual changes and, in economic terms, with a slowdown in momentum. This is interesting as the turning point would occur at a point where the level of industrial production was still some 10-15% lower than pre-crisis peaks and indeed still lower than in 2005 (2005 = 100 in the charts above).
Further evidence today comes from the overall Flash estimate of Q2-10 European GDP which shows that Germany remains the only real stellar growth story. Over the quarter both EU27 and EU16 grew an impressive 1.0% driven by strong growth rates in Germany and France. Greece on the other hand saw its contraction accelerating and over the year both Greece and Spain saw contractions (Spain saw a 0.2 expansion over the quarter).
In this sense, European growth remains very skittish and I think we will see a double dip in the Eurozone in H2-10 while the US should just avoid one. Finally, I maintain my view that although growth will slow to the detriment of risk assets, there is almost no risk of a global double dip due to continuing strong growth in Asia and Latin America.
Where goes them US treasury yields?
Probably the most hotly debated lately has been the relentless decline in US treasury yields and by extension the idea that deflation has become an entrenched reality at the same time as stock markets have soared. Now, there are a lot of ways to skin this cat which should be evident on the basis of the absolute storm of punditry on this issue lately. A couple of important general points are worth mentioning here. First of all, this is closely tied to the the prospects of a double-dip recession in the US where some commentators have recently flagged the issue that while conventional recession indicators point to sustained growth these very same indicators rely heavily on the slope of the yield curve (e.g. Albert Edwards from Soc Gen and BCA have recently made this point in their research). The point is that since short term rates (and by derivative yields) are already close to zero there is no way that the yield curve can invert (a traditional harbringer of recession) even if a recession is imminent. Secondly, it would be nice to be able to argue on the basis of some simple arithmetic rule here such as e.g. mean reversion, but the problem is that even when deflated by the annual change in CPI the real yield on US treasuries (2y and 10y in this case) are still trending (downwards).
I will neatly sidestep any discussion about whether this is end of the bull market in government bonds since this is a chicken-and-egg type of discussion. If you believe in perma-deflation, short term yields will hover around zero and, c.f. the latest from Rosenberg, the Fed will try flatten the yield curve by moving in on the long end. I am leaning towards this scenario for 2011 and thus lower yields are here to stay (at least in nominal terms). If we take the current message from the 2y and 10 year yields at face value and assume, naively, that the average inflation rate for 2010 will prevail as an average over the next 10 years the outlook is poor with real yields on the 2y notes negative and only slightly positive for the 10y horizon. Going back to Rosenberg, what he is essentially saying is that bringing on additional QE might serve to flatten yield curve from the long end of the spectrum as the Fed begins to massage yields at longer maturity.
Indeed, as a result of record low yields on 2y notes the 10y2y curve has never been steeper than is currently the case and while we would expect short term interest rate to flatten it as we move into recovery, this time might be different (going back to Rosenberg’s argument again even though 10y is not long term in the ultimate sense of the word when talking about treasury yields).
So where do they go? Let me answer that question with another (rhetorical) question. Do I believe that QEI, II, III etc will work and ward off deflation in the US? Yep, I do and as such I see higher yields going forward, but for now I am very comfortable with the call that short term yields will remain low for at least the next 12 months and that Rosenberg is likely to be right. So, not quite time yet to take a random pot sho(r)t at them bonds.
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[1] – Link this to the notion that global imbalances are driven by real estate price fluctuations and housing market dynamics and you should have that fuzzy feeling by now.
Data is from the ECB and FRED (St. Louis Fed)
By Claus Vistesen, on August 6th, 2010
Team Macro Man has a nice perspective on what deflation might mean in the OECD context and it is difficult to disagree with the underlying rationale.
One sector that is glaringly not singing to the Deflationistas’ hymn sheet is commodities. While a rapidly-growing global population continues to compete, like bacteria on a Petri dish, for the basic resources of food and energy, the input component to basic living will keep local prices firm even in an environment of other localised deflationary pressures.
The world is still steadily competing for raw materials, so any slow down in the West can only express deflation through lower wages as competition for jobs tightens and hence labour cost inputs fall. So whilst service sector (higher labour component) may see a higher relative price deflation, the basic cost of survival, food and energy to the individual stays the same, or rises as we are now seeing.
That isn’t an individual enjoying deflation, that’s an individual suffering poverty.
I remain inclined to believe that the biggest problem for most OECD economies in the coming decades will be deflation (and the subsequent increase in the value of real debt) rather than inflation. But there is a world outside OECD too and especially commodities could very well be a source of inflation and thus in some sense stagflation (with the added spice that our relative wage in the West may fall at the same time)
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If you like me are prone to the occasional what the h’ck is going here mantle; this rap up by Gwen Robinson at FT Alphaville provides a good overview of the recent flurry. Highly recommended as the first read this Friday morning or as weekend lecture.
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Jean Tirole is professor in Economics at Toulouse University and back in September 2009 he penned a very interesting article on illiquidity and what it means for a balance sheet (of a bank) to be liquid and illiquid.
The recent crisis was characterized by massive illiquidity. This paper reviews what we know and don’t know about illiquidity and all its friends: market freezes, fire sales, contagion, and ultimately insolvencies and bailouts. It first explains why liquidity cannot easily be apprehended through a single statistics, and asks whether liquidity should be regulated given that a capital adequacy requirement is already in place. The paper then analyzes market breakdowns due to either adverse selection or shortages of financial muscle, and explains why such breakdowns are endogenous to balance sheet choices and to information acquisition. It then looks at what economics can contribute to the debate on systemic risk and its containment. Finally, the paper takes a macroeconomic perspective, discusses shortages of aggregate liquidity and analyses how market value accounting and capital adequacy should react to asset prices. It concludes with a topical form of liquidity provision, monetary bailouts and recapitalizations, and analyses optimal combinations thereof; it stresses the need for macroprudential
policies.
The best academic read I have a had in a long time.
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Eliana Marino takes a look a migration in the Baltics and tells one of the great unsung stories of this crisis and what it means when you lose your working age people to net migration;
- emigration of working age population makes the demographic burden increase: the number of inactive people (children and retired people) exceeds the number of active people, creating serious challenges for the sustainability of the welfare system;
- the most part of the outflows consists of working age population (from 15 to 65 years old) that includes people in reproductive age (from 15 to 49 years old). A huge number of emigrants in this particular age group means a further reduction of the natural increase of the population. In fact, they will probably have their children abroad or the migration decision itself will discourage the creation of numerous families.
I need to write a paper on this!
By Claus Vistesen, on July 21st, 2010
BBC’s travel program Fast Track had a story about how Santiago has been working hard since the earthquake to (re)build its position as a cool global city. I have never been to Santiago (let alone Chile) so I cannot say whether there is any position to rebuild or whether Santiago isn’t simply moving up and ahead regardless of the recent blow to tourism in the wake of the earthquake. However, what I can say for certain is that when it comes to Chile’s economy at large it is in no need to rebuild anything; it is both global, cool and very strong.
Enviable Economic Performance
Let us begin taking stock on the performance of Chile’s economy in the past two years compared to the US and the EU16 in order to see that while the crisis indeed has been global (and still is) notable divergences are present.
Chile’s economy contracted through three quarters from Q4-08 to Q2-09 but has since returned to growth and, crucially, seems to have returned to trend growth unscathed from the fangs of the economic crisis which will have wide repercussions in the rest of the OECD for many years. In this sense, Chile entered the crisis unlevered and with sound demographic fundamentals which precisely gives the economy the ability to reach escape velocity and quickly resume positive output growth. As a backdrop it is exactly this pulling power which many economies in the OECD don’t have which again means that for us to find a solution to this we have to find a way to export our way out of trouble but since this is not possible for everyone at the same time it does represent us with a unique challenge.
This is not the case however in Chile where the economy expanded at a heaty pace of 11.3% and 13.7% in Q4-09 and Q1-10 respectively (yoy), numbers which are bound to be considerably lower going forward especially since the effect of the earthquake in February will cast a shadow over Q1 GDP figures which may still be revised down considerably once the full effect has been factored in. The alternative is that the effect will be moved forward into Q2 numbers, but this is ultimately an accounting question.
Moving closer to real time developments the main activity index (the IMACEC) indicates a steady and ongoing expansion of Chile’s economy even after the blip which occurred as a result of the earthquake (showing up in the March reading as it happened in end February).
In May, the IMACEC stood at 130.9 (2003 = 100) which is the strongest reading in the index’ history and further encouragement has also come from the fact that May was the first month in which industrial production showed a proper increase on an annual basis after having moved sideways in Q1-2010; industrial production expanded 3.3% on the year. This points to an economy on a strong footing although some might note that at this pace and with the headwinds currently facing the global edifice the only way from here is down. I would agree in the main here as Chile may well give back some of the fine H01-10 performance as we move into H02-10 but Chile should be able to stand its ground and will expand at a healthy clip in 2010.
This view is supported by recent upward adjustment of economic expectations across the board even if the current expectations of continuing interest rate tightening may be overdone.
Regards, the evolution of GDP in 2010 the expectations remains fixed at around 4.5% to 4.8% which is around trend output according to the central bank’s estimations. The 4.25% target for the monetary policy rate in 12 months implies a steep tightening schedule from the current level of 1.5% and many analysts have voiced caution that interest rate will climb this much in a 12 month horizon. This view reflects both the fact that the central bank may be too linear in the way it has set its 12 month target interest rate as well as it reflects the market’s perception that appreciation of the Peso may become an issue as the yield advantage of Chile increases relative to the USD and Euro.
Strong Fundamentals
So, I am arguing that Chile is doing fine and that she is likely to continue the recent impressive expansion which is likely to put Chile even more at odds with what is expected to be a slowdown in the developed world. However, do the fundamentals back this?
Indeed they do and the focus should be on two aspects; demographics and a sound management of copper windfall.
If we begin with the former there are naturally many ways to spin a story on the graph below.
One could for example point to the fact that the population share of 20-49 is peaking right at this moment and is set to decline hereafter which means that Chile might just be running on the last fumes of full capacity. But this would be missing the big picture I think. In this sense, I think the main point to take away here is the remarkable stability of the population share aged 35-54 throughout the next 40 years (estimated of course, but we are fairly sure that this fits unless we get some kind of exogenous shock). I am emphasizing this because this particular age group has been found [1] to correlate well with GDP per capita levels and growth. The key to Chile’s relatively stabile demographic trajectory is to be found in a very favorable demographic transition (at least when it comes to economic growth). Consider then that from 1983 to 2009 fertility in Chile decline from 2.5 children per women to around 2 in 2009. This trajectory is actually what one would expect if applying basic transition theory, but in the real world only a few economies have made the transition to achieve a somewhat stabile level at replacement fertility. The general rule is that fertility undershoots replacement level and has mighty difficulties recovering if at all.
This, more than anything, makes Chile stand out and as an emerging economy turning developed this aspect of the Chile’s economy and thus the absense of a very quick and steep fertility transition is, to me, a key reason for Chile’s success.
Another reason for Chile’s strong economic performance is its copper reserves but more than anything the proper management of this to avoid dutch disease and to build up a strong fiscal position and indeed a sovereign wealth fund in which large chunks of the copper windfall has been stashed away. Naturally, this does not make Chile less dependent on copper as such, but it means that the economy has been able to avoid adverse effects from the volatility in growth that often comes from relying on commodities for revenue (and growth). In numbers, Chile has historically aimed at an annual fiscal surplus of 0.5%/GDP to act as a counterweight to the incoming copper revenues. Between 1996 and 2006, Chile’s public balance averaged 1.5% of GDP a position much better than that held by its peers in East Asia and Latin America. From 2005 to 2007 the structural surplus as a percentage of GDP was 1% and around 0.5% in 2008. However, the pure fiscal surplus, in 2008, as a percentage share of GDP stood at 8.1% which is quite extraordinary on any measure. Although the crisis and the earthquake are sure to have made a dent in these impressive figures the fact remains that on a gross basis Chile’s government debt remains very low (6% of GDP in 2009 and 2010) whereas the net debt level is firmly negative (i.e. book value of financial assets exceed that of financial liabilities).
Upwards and Onwards
Does this mean then that there is nothing stopping Chile? Actually, yes.
A renewed severe global slowdown or even a relapse into the financial crisis as well as continuing uncertainty surrounding Chinese momentum and thus copper prices are all factors that could derail Chile’s economy in some way or the other. However, it is fair to assume that in the event of an external shock Chile should fall less and rebound more strongly than many other economies and this means that Chile is likely to perform well in relative fashion.
Certainly, I don’t want to come of off as complacent but looking at the evidence before and with the qualifier that Chile is not hit by a surge of severe earthquakes (which of course will accumulate in the loss of output) I really cannot see where the stumbling block lies for Chile. In this sense it seems, for now, to be steady as she goes in Chile.
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[1] – See this for example.
By Claus Vistesen, on June 28th, 2010
Blog post series, like the vuvuzela, is the new bacon; it works with everything and with John Hempton’s recent excellent series on the economics of default in the Eurozone and Edward’s recent postings on AFOE in which he pulls out some of our old paper abstracts has inspired me to a series in which I try to pin point exactly how demographics and macroeconomics interact and where I believe we need more focus and work.
When it comes to the overall link between demographics and macroeconomics we already have a number of core workhorse models in the form of the life cycle and life course framework where the former deals with consumption and savings decisions as a function of age and the latter deals, broadly, with life time events and their individual and aggregate importance on economic dynamics. The adequate impact on the macro economy from the dynamics of demographics must then be developed as a function of the attempt to do two things; firstly, to continuously develop the life cycle and life course theories themselves and secondly to seek out new ways to apply life cycle and life course theory to existing macroeconomic problems and themes.
In the first series, I will begin with the latter. Overall, I will highlight 6 areas where demographics enter macroeconomic theory and research as an important variable and I will try to offer my view on where to progress further. I will begin with two classics in the form of growth theory and open economy dynamics.
Growth Theory
Firstly, I need to say that I am not an expert on growth theory and this represents somewhat of a problem since growth theory although somewhat out of vogue at the moment has grown to become an extremely diverse field with a wide number of different schools and discourses. For the purpose here it will suffice to note that most economists today still use some form of the classic production function framework which has its roots in the work by Charles Cobb and Paul Douglas in 1928 and was popularized in 1958 by Solow’s famous article. This is what it looks like;
Where Y is output, K is physical capital, A is the illusive residual or more specifically technology/production function, L is the size of the labour force and H is a measure of human capital. Now, I certainly won’t do any math at this point and it is important to note that the functional form may take many exotic forms (which are not necessarily Cobb-Douglas), but just to give you one example the following is a Cobb-Douglas production function which incorporates human capital as above (here with constant returns to scale);
The key point I want to emphasize here is simply that we have output as a function of some input and that we would like to account for and explain the dynamics and behaviour of this input. How might we imbue this model with reasonable characteristics that reflect demographic dynamics? As it turns out, we already have some pretty solid frameworks to deal with this questions and we can see this by looking at the inputs one at a time.
The evolution of capital (K) – In most traditional models the evolution of capital is simply expressed as the fraction of income save minus any depreciation of the capital stock in the last period and here of course we have several workhorse models to show demographic dynamics that are all wrapped up in the form of the life cycle hypothesis of savings and consumption. Usually and since most of these models are constructed on the basis of Walrasian microfoundations, we have some form of intertemporal optimization problem ticking away in the background which assumes an OLG (overlapping generations) form. The classic model here is the Diamond model who is based on Diamond (1965) which is the father of all OLG models, but over time a plethora of different OLG models have been developed with differing degree of analytical complexity.
The basic problem here though remains the concept of the steady state which means that we must construct model such as to allow the change of capital through time (or its derivative with time) to be 0 in the long run. Please note here that this condition is not imposed on the basis of empirical behaviour but on the basis of (mathematical) analytical tractability. So, apart from the uncertainty surrounding exactly what this ”long run” is it also locks in the analysis and assumes away a large part of the important aspects of even basic life cycle behavior. Specifically, the idea that once reaching a steady state any change in the savings/consumption rate will one have transitory effect and that the economy will automatically (and always) converge to the same growth rate/state as before is a problem. Essentially, the whole idea of a steady state whether be it in the form of an exogenous or endogenous growth theory framework is a huge problem since it is evident that such a thing does not exist. And even if we could establish over a very long run horizon that such an average/constant path is a good approximation we would be ironing out all the interesting and important questions in the process.
The evolution of human capital (H) – The adoption of human capital into the growth theory framework is famously due to a paper by Mankiw, Romer and Weil in 1992 in which human capital is proxied by rates of schooling and thus the perspective becomes one of the quality of human capital and to the extent that the formation of human capital also includes the evolution of the population (or perhaps working age population) we can say that this is a direct way in which demographics enter the framework. Again, we might simply ask here; to what extent does the aggregate quality of human capital in an economy depend on the age structure of its population and here I am not only talking about the level of education but much more broadly about the idea of innovative capacity as a function of population structure.
The evolution of technology (A) – Technology and productivity are famously assumed exogenous in the Neo-Classical tradition while New Growth theory as it was developed in the 1980s and 1990s emphasised the need to specifically account for the evolution of technology. Today, I would venture the claim that there is a consensus that productivity and technology is a function of what we could call, broadly, institutional quality which encompass almost anything imaginable from basic property rights to the level of entrepreneurship. Indeed, a large part of research is still devoted to pinning down exactly which determinants that are most important here both across countries and through time. Now, I would argue that, in the context of standard growth theory, this is where the scope for the study of the effect of population dynamics is largest. Thus I don’t think it is unreasonable to expect the level and evolution of productivity growth and technological development to be a function of the current population structure but also its velocity which is a function of e.g. migration (new inputs?), future working age size etc. Also, this is also where human capital and the evolution of technology is joined at the hip through the idea of innovative capacity and readiness.
As you might have inferred from the exposition above, I have some difficulties with growth theory. I can admire the framework for its internal logic and I can see why it is an important part of a macroeconomist’s toolkit, but I also think that growth theory (as I describe it above) has outlived itself. In this sense, most of the questions that we have as economists when it comes to the evolution of growth and welfare of our economies both individually and through their interaction is not addressed by growth theory. Especially the effect of an ongoing and ruthless process of ageing is completely impossible to analyse in the standard framework. Naturally, I am also being a bit unfair here since the kind of growth theory I am describing above is also too simple to give adequate credit to where the field is today. For example in relation to demographics, I am grossly overlooking important strides in the development of OLG models which have been perfected continuously so that we today have a very large battery of very complex models. But also more generally, growth theory is being used today to produce a lot of useful research. As I say, it remains a key tool in our toolbox.
Yet, the basic growth theoretical setup remains flawed in key a number of un-salvagable ways. Concretely, specifying a production function and specifying the underlying inputs as differential equations through whose solution we reach a steady state equilibrium is not, in my opinion, the way to go. Thus and in an intuitive sense I feel much more at home, for example, in the company of evolutionary growth theorists [2] whose argument and methodology is more agile. In summary then and as I try my utmost not to become a hostage of the notion of a steady state I will simply make the following observations in the context of what we macroeconomists consider the main inputs to growth where the ”age” is simply an unspecified collection/function of variables that pertains to fertility, age structure, mortality etc (and of course a whole slew of other factors, but for the sake of argument let us keep it monocausal here).
Where age in the context of the capital stock relates to the size and evolution of the capital stock as well as savings and investment dynamics, in the context of human capital it may be argued to enter directly, but may also affect the quality of human capital. Finally, I think that the impact of demographics on innovation and especially the idea of velocity of innovation and innovative capacity represents an area which is not well understood. In general though and short of letting some variant of demographics enter directly, I think an important research program would be to examine the effect from demographics on the inputs to growth which we traditionally operate with. Especially, the process unprecedented process of ageing is a completely new phenomenon here in the context of traditional growth theoretical analysis.
Open Economy Dynamics
An enduring feature of macroeconomics is that the entities we study are not black boxes but interdependent entities who interact in very complex ways in the global economy. This statement was true 40-50 years ago and today it is almost a cliché. In fact, for non-macroeconomists it must seem very strange that we still distinguish so strongly between closed and open economy analysis as the use of studying the former must surely be almost nill. I would agree with this statement but simply note that important things do actually happen when we go from a closed to an open economy and the way this transition is operationalised is important in itself.
Now, I could write a lot about this (in fact, I have penned a whole thesis about it), but I will only cover the essentials. What you need to know upfront are two things. The first is that the economic theory used to handle the effect of age structure/demographics on open economy dynamics is again the life cycle framework and, in most cases, we still have a OLG representative agent model taking care of the microfoundations. Secondly, it is important to be aware of the concrete specifics of the transition from a closed to an open economy. Luckily, this can be handled by some very simple algebra from macroeconomics 1-0-1.
The whole point is to find an expression for savings, so for the closed economy we have;
By definition every unit of output has to equal a unit of income, and national income in any given period can either be saved or consumed. This means that national income can either be put aside for saving or consumed through government (G) or private consumption (C). In this way, we define national saving in any given period as;
This is a fundamental result in basic macroeconomics and what is equally fundamental is why this changes in one key aspect when we move into an open economy setting. We then have;
With (x-m) equal to the trade balance and by doing the same exercise above we get;
In this context and remembering that the life cycle hypothesis tries to map consumption and saving as a function of age, the transition from a closed to an open economy becomes crucial in order to see how demographics may affect open economy dynamics. As such, allow me to quote the following passage of my thesis which I find myself coming back to when thinking about this topic;
The best way to think about this [3] is to imagine that savings and investment are in a race governed and controlled, as it were, by the transition in age structure that occurs as a result of the demographic transition. Initially, as the transition sets in with a decline in mortality and where fertility only follows with a lag, investment demand outruns the supply of savings and the economy is running an external deficit. Steadily however, the supply of saving catches up with investment demand which itself begins to decline and thus the external balance moves into a surplus. Finally, the pace of savings accumulation is replaced by outright decumulation (dissaving) and the external balance moves into deficit as savings decline faster than domestic investment demand
This is stylized of course, but especially the idea of the race between savings and investment is a very helpful metaphor. Consider then a closed economy; in such a setting there can be no race as described above since savings and investment will be tied together at all points in time, but in an open economy savings and investment dynamics are exactly what provokes relations between economies and more specifically, the fact that the economies have different preferences for savings and investment at different points in time. This gives a very strong foundation for thinking about how demographics affect open economy dynamics.
Concretely, and in order to tie the argument up on the underlying theory capital flows occur precisely because economies have different intertemporal preferences for consumption and saving and since this intertemporal preference itself is a function of age (through the life cycle/OLG framework) demographics become a driving force for international capital flows.
This as it were is also where the fun begins since exactly how this process should be understood both from the point of view of the individual economy, but also in a global context remains, for all intent and purposes, an unresolved question. Surely, we have studies that use basic life cycle frameworks to simulate capital flows between economies and they do have some intuitive appeal and explanatory power, but they are hampered by, in my opinion, by an inadequate understanding of the life cycle thesis and how exactly it manifests itself. As I noted in the beginning, part of all this also requires a continuous development of the life cycle hypothesis itself and here this becomes important. Personally, I have cast my eyes on two areas of research where I believe that the influence of demographics on open economy dynamics is important.
1 – Global Imbalances
This represents an enduring feature of the global economic system and while everyone can agree that they need to be resolved some way or the other I think that the proper understanding of demographics shows us that they are essentially structural. Especially on the side of surplus economies I have argued (both in my thesis and in genera) why we cannot suddenly expect economies such as Germany and Japan to do their part and crucially, why we should expect more economies to venture down the same path as they are also ageing rapidly. Importantly, this provides a concrete theoretical spin to the question everyone seems to be asking at the moment of who exactly is going to run the deficits? The pessimistic answer here is no-one and herein lies the rub.
2 – Export dependency
This one is essentially the concrete theoretical proposition used to make the argument above on global imbalances. Ageing leads to a decline in domestic demand and in a closed economy there is really not a lot you can do; savings/investment will fall and consumption will be lacklustre since there is no underlying dynamic to feed it other than dissaving. However, in an open economy you can fight this through claims on other economies or put in another way, you can save more than merited by domestic demand and thus you can invest your savings abroad. Note here that technically this is exactly what e.g. Germany and Japan are doing in the sense that their excess savings have to be matched by excess borrowing/investment demand elsewhere.
I am still developing these two areas, but there are plenty of meat on this topic I think. One crucial task is to develop the life cycle hypothesis on the basis of observed behavior of economies as they age and another is to.
Stay tuned for the next post in this series which looks at the influence from demographics on asset prices, demand, and return and composition of consumption. Suggestions and comments on potential omissions on my part are welcome.
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[1] - Most often operationalized through an OLG framework.
[2] – Evolutionary Growth goes back to this one “Nelson, R.R., Winter, S.G., 1982. An Evolutionary Theory of Economic Change. Harvard University Press, Cambridge, MA” and is a must read I think. The work by Jan Fagerberg is a good place to begin as well as for a more modern exposition.
[3] – I.e. demographics and savings and investment behavior in an open vs closed economy
By Claus Vistesen, on May 25th, 2010
Nothing is so bad, that it isn’t good for something
So goes an old adage in my home country (and I would imagine elsewhere too) and perhaps if hard burdened Eurozone policy makers and investors are finding it hard to find any kind of (positive) silver lining in the current debacle, they may just want to remember that old of oldest saying. I am of course talking about the Euro here and while its recent fall from grace has been linked to all kinds of nastiness in the form of a Eurozone break-up/collapse as well as the final nail in the coffin of those who once argued that the Euro would surpass the USD as the global reserve currency [1], it is also going to act as a much needed leg of support to those economies most in need of export performance in the absense of domestic demand. As the tally of the financial crisis increases and as the demographic transition soldiers on this is fast becoming all the Eurozone economies combined [2] (click for better viewing).
Since the beginning of 2010 the Euro has depreciated 14% and 16.5% agains the USD and JPY respectively and this is remarkable in an environment where risk aversion has unwound. In short; when it comes to the game of cards in terms of global liquidity/capital flows where holding old maid means that you buy bear the brunt of intra-G3 appreciation. This is what I wrote in my sneek-peek into 2010 G3 FX markets;
In an G3 context, 2010 clearly holds the potential for Dollar strength, but timing and intensity is going to differ. Most major research houses see the USD/JPY as a strong candidate for a correction that could move the pair back in the 100s. I concur. Whatever speed the US economy will have in 2010, Japan will be the laggard and the BOJ will be dragged kicking and screaming into a full out battery of QE measures.
Buy the Old Maid. If the rally in risky assets continue into 2010 and beyond, the Euro will be holding the Old Maid amongst the G3. If the recovery is stopped in its tracks it is very likely that it will be from an event conjured in Europe making the USD holder of Old Maid. The former looks the most plausible scenario at this point in time with the notable qualifier that the USD should strenghten against the JPY. In this way, the Old Maid will shift hands from the JPY to the Euro and potentially the USD with the outlook for the EUR/USD not easy to call.
In my book the EUR/USD looks way too high even in the 1.40s. However, we have seen before that this pair may continue to rally so it is worth treating this one with care. Societe Générale sees dollar weakness sustained (except versus the JPY) well into 2010 and thus the EUR/USD continuing to drift upwards. I only conditionally agree. Especially I would emphasize the fact that the risks to the Euro, by far, out match those to the USD at the current juncture. In this way, I am less sanguine when it comes to the continuation of the ”recovery” and thus the rally in risky assets.
I will let my readers judge the accuracy of my argument but I don’t think it is too far off the mark. Consequently, I was not particularly suprised by this piece today running across the Bloomberg wire that FX punters and other of their ilk are beginning to look to the Euro as a source of global liquidity to play the carry wheel in high yield economies.
(quote Bloomberg)
The fastest convergence in short-term interest rates in almost a year is making the euro a surprise addition to currencies used to finance investments in higher- yielding assets. “The hot guys are moving into using the euro as a funding currency,” said John Taylor, who helps oversee $7.5 billion as chairman of New York-based FX Concepts LLC, manager of the world’s largest foreign-exchange hedge fund. “It’s not quite as cheap as the yen but it’s a lot safer in a crisis, because the worse the world looks the worse the euro looks.”
Borrowing in euros to finance an investment in the Australian dollar, New Zealand dollar, Brazilian real and Norwegian krone returned 10 percent in the past 6 months, according to data compiled by Bloomberg. The same trade using the dollar instead of the 16-nation currency resulted in a 7.5 percent loss, and a 7.4 percent decline with the yen. Deteriorating economic prospects in the euro area have helped push down the cost of short-term borrowing in Europe relative to the U.S. The London interbank offered rate, or Libor, for three-month loans in euros fell to within about 14 basis points, or 0.14 percentage point, of the dollar rate on May 21, from 26 basis points at the end of April and 40 on Dec. 31, according to data from the British Bankers’ Association.
Libor for loans in dollars for three months was 0.497 percent at the end of last week, compared with 0.636 percent for euros, the BBA said. The European Central Bank’s main refinancing rate is 1 percent, while the Federal Reserve’s target rate for overnight loans is as low as zero.
Now, I am sure that the Eurocrats would rather have the Euro gunning for reserve status and certainly this goes for the ECB hawks who have so far, and decisively in the context of the initiation of QE, been drowned in a sea of dove feathers. However, being a carry trade funder has its advantages too; just ask Japan who has benefitted from this role a long time up until of course the Fed rushed into QE on the back of the financial crisis as well as it appears that Japan’s own horrible growth and debt outlook has taken the, temporary, backseat to the crisis in Europe. As Andreas Hahner, a money manager at Allianz Global Investors, is quoted by Bloomberg; you need three things to be a carry trade funder. Low interest rates(check!), depreciation/relative weakness (check) and low volatility (well, check for now). However, Mr. Hahner is right to point to the fact that the bounce back in the Euro could flush out many a European version of Ms Watanabe.
But then again, which boounce back would he be talking about here?
Certainly, in relation to the G3 the big problem is that the long term growth prospect for the US looks decidedly brighter than for Europe and Japan (demographics remember) and this is a “problem” since we were also supposed to correct those blasted imbalances. In fact, one cannot help but feel that if Germany really wants wealth preservation and vigilance against inflation, let them have it, but they need to know what it means. I would consequently submit that in terms of keeping the Eurozone in one piece and in its current form will require a sea-change at the ECB. We have seen the first steps to this with the intiation of QE, but what markets have not faced up to yet is the duration of this policy measure. It won’t just go away folks; it is here to say. Whether it also means that the Euro is now to become a carry trade funder of choice is a significant question since if this is the case, it means that it will also begin to trade like one. I for one would not be surprised to see this and investors should take note of the change in discourse on the Euro here [3].
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[1] – About time too; some of us has argued this for the better part of the last 3 years!
[2] – In this sense, there IS convergence which is actually an interesting point to ponder in terms of general reflection.
[3] – Well, of course, you should not take note of me not being surprised 
By Claus Vistesen, on April 15th, 2010
With so much going on at the moment and so many themes fighting to claim the main market discourse, I am in the mood for some random shots. First of all and to my continuing regret I have never actually got to thank Niels C. Jensen from Absolute Return Partners for the nice coverage I got way back in October 09 when Mr. Jensen discussed my thoughts on demographics and the life cycle.
So, let me repay by pointing towards Jensen’s recent two monthlies which form the basis for this round of random shots. Both are very much worth reading and in some sense they go together to form a common narrative, but especially the second one where Niels is blowing echo bubbles is mandatory reading I think. The themes taken up by Niels are well known and so is the underlying narrative, but this does not mean that it is not worth repeating; I will Niels set the scene;
In last month’s letter I looked at the challenges confronting the world’s baby boomers based on the assumption that we are in a structural equity bear market, which implies below average returns for equity investors for several more years to come. Central to this forecast is my expectation that household de-leveraging, which is now underway on both sides of the Atlantic, has much further to run. In other words, we are in a balance sheet recession. When that happens, debt reduction becomes the priority. Savings rise and consumption falls at the expense of economic growth.
Please note that this forecast is predicated on a 5-10 year time horizon. Within a structural bear market – which is characterised by falling P/E ratios – it is certainly possible to have cyclical bull markets, so it is by no means one-way traffic. As you can see from chart 1, since the 1982-2000 structural bull market came to and end, we have enjoyed two powerful cyclical bull markets; however, global equity prices remain at 2000-levels.
(…)
However, this is not the same as saying that it will always be a losing proposition to invest in equities. Equities can, in fact, do quite well for long periods of time despite the negative undercurrent. This is what the perma-bears do not understand. They assume that structural bear markets equal negative returns and that is not necessarily the case.
Thus and to clarify, what is referred to here as an echo bubble is the rally we have seen since March 2009 and thus evidence that while structurally, deleveraging and low trend growth will be the main driving force, that does not mean that equities cannot and will not perform extraordinarily well for long passages of time. I mean, who wouldn’t wish that they bought with everything they got back in March (I know I myself feel a bit peeved over not piling in).The broader issue of course is that while smart money may very well learn to navigate such an environment the smart dumb money (i.e. those who buy and holds the market) may realize that the reward from such a strategy may turn out to be less than splendid. And since this is basically a proxy for the return on savings, it means that permanent income will fall which means that consumers will need to save relatively more to compensate, and then we get the problem of a lack of consumption and aggregate demand and … on and on we go!
On this, I agree that deflationary v inflationary forces will feature a tug-of-war for many years to come and, like Niels, I tend to favor the former. However, when pointing to Japan as an example of how continuous attempts have failed to spur inflation (and is still failing) I do think it is important to qualify that this goes strictly for domestic inflation. In this sense, what has become known as the Yen carry trade (and recently USD carry trade perhaps?) is merely a proxy for much broader and structural tendency which signifies how central banks have lost control over where the liquidity they provide is applied. This goes in both direction. In Japan, the liquidity create slips through the back door and ends up e.g. in Brazil or New Zealand who, in order to combat domestic inflation, are busy increasing interest rates only to that it sucks in more liquidity (or, if you will, purchasing power).
Clearly, with US rates stuck at near zero this provides a huge push for global liquidity and even though I think that the US (and the UK) will eventually succeed in getting inflation (and quite possibly, a lot of it), the fact that these economies may withdraw liquidity slower rather than faster represents strong sheet anchor for excess global liquidity and thus although we may be in a structural bear market, it is also a market with a high level of volatility.
This leads me to the following three themes I am following at the moment inspired not only by Niels’ thoughts but also by the recent themes laid out in Variant Perceptions monthly (which is sadly not available online).
1. I accept the idea of a structural bear market but interpret it as investment lingo I guess for broader macro reality that we are now in a situation where we need to delever and that will be deflationary in domestic OECD economies (i.e. this is German austerity writ large). This, I would assume, is tightly connected to lower trend growth. In this sense, demographics (which I tend to focus on) and the defacto excess leverage (regardless of underlying capacity) serve as a ball and chain and it represents a structural break both in terms of behaviour by part of economic agents but also in terms economic growth.
2. Higher volatility. Why? Because just as Japan may fail in creating domestic inflation and just as the US/UK may find it hard to create domestic inflation (although at some point they will, for sure!) they may all create inflation and bubbles elsewhere. Please do read this again if you did not have the chance.
I guess it goes back to the premise that while we may in a situation where growth and equity returns (beta!) are sluggish, we will still see bull markets that lasts (well the current one is running on a year now no?) and more importantly; there will be economies who are able to suck up excess liquidity but they are outnumbered by economies with a desire of excess (external savings) and this is what leads to volatility in asset markets and the real economy.
3. Who is running the deficits? This is an old time hobby horse of mine, but still one which is extraordinarily important. In short; where will bubbles form and why? Emerging markets seem certain. But more importantly and using demographics as a yardstick the equilibrium is changing. Thus, we are all ageing, so we are all moving towards the same “preferences” for a high level of desired external savings as well as more and more economies will struggle with domestic deflation. How this ends is still an open question and it is also the straight line my theoretical work draws into the real world.
Lastly, and now moving with some truly random shots, I think Niels has some interesting points on investors and commodities and how these markets are not really suited for the kind of activity they are seeing. This is of course a direct effect of all those who really think that we are heading to hell in an express elevator and that the fiat system is collapsing etc. You all know the story I guess. Yet, after having looked recently at Chile and thus copper, I am sure that here is a metal which looks very, very bubble prone! Finally, Niels touches on China and the fact, as we have talked about, that as China moves into a trade deficit would a freer Yuan actually appreciate? Or would it in fact depreciate? Well, we will see soon enough I guess since it turns out that Niels was right here. Consequently, news has just come in off the wire that China posted its first trade deficit in six years in March as the trade print came in at a $7.24 billion deficit. Q1-10 is still a surplus but is this the first signs of true and real rebalancing? Well, color me (very) skeptical here that China will be pulling the global economy anywhere through a trade deficit that is not based e.g. on stockpiling of base metals and other commodities, but the ball is in my court as a skeptic with these latest numbers I fully accept this.
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