European GDP: What Went Wrong

by: Sami J. Karam

Summary

First the two World Wars, then a decline in the birth rate.

Poor demographics have led to weak domestic demand.

Rising dependency ratios present a new challenge.

Newspapers these days are full of stories on World War I which started 100 years ago. They are also full of stories on today's anemic European economy, as for example with Italy's negative growth rate in the second quarter and France's struggle to reach 1% GDP growth this year. At first blush, these two sets of stories are unrelated. But on closer look, it is apparent that the economy today is a distant echo of the war a century ago. And it all comes down to Europe's demographics.

In my view, there are essentially three main catalysts of economic growth: innovation, demographics, and a favorable institutional framework. To illustrate this, imagine that a firm develops the best smartphone in the world but that there is only a potential market of 1 million buyers. Clearly, the wealth created by this innovation would be far smaller than if the potential market was 100 million buyers. Thus the importance of demographics.

Now imagine that there is a market of 1 billion people but that there is no innovation of any kind. In this case, wealth creation would be greatly stunted and, with few new assets being created, wealth would become essentially a game of trading existing resources. Thus the importance of innovation. Finally, imagine a country where institutions are weak, where contract law is weak, where access to capital is difficult, where the government is corrupt and political risk is high. Here again there would not be much innovation because there would not be much capital or much incentive to innovate. Thus the importance of a favorable institutional framework.

Too many deaths

So going back to Europe, we could say that it has some innovation and that it has a favorable institutional framework, though in both cases to a lesser extent than the United States. What Europe lacks most is a strong demographic driver. It is enlightening in this regard to look at the sizes of European populations in the year 1900 vs. today:

Population (millions) 1900 2014 Growth CAGR TFR
France 38 66 74% 0.5% 1.98
Germany 56 81 45% 0.3% 1.42
Italy 32 61 91% 0.6% 1.48
Russia 85 146 72% 0.5% 1.53
Spain 20.7 46.6 125% 0.7% 1.50
United Kingdom 38 64 68% 0.5% 1.88
Brazil 17 203 1094% 2.2% 1.80
China 415 1370 230% 1.1% 1.66
Egypt 8 87 988% 2.1% 2.79
India* 271 1653 510% 1.6% 2.50
Indonesia 45.5 252 454% 1.5% 2.35
Japan 42 127 202% 1.0% 1.41
Mexico 12 120 900% 2.0% 2.20
Nigeria 16 179 1019% 2.1% 6.00
Philippines 8 100 1150% 2.2% 3.07
United States 76 318 318% 1.3% 1.97
Click to enlarge

* includes India, Pakistan, Bangladesh and Burma.

Source: Various, United Nations. Data may include errors. Estimates vary due to shifting borders and uneven reporting.

Two important points stand out:

First, in 1900, European countries were not only the world's economic and military powers. They were also among the most populous countries in the world. By contrast today, Russia is the only country in the top 10 most populous. Then Germany is 16th and France is 20th. More importantly, some of the new demographic powers, India, Nigeria, Egypt, Mexico, the Philippines and Indonesia, are growing at a healthy clip, as can be seen from their Total Fertility Ratios (TFR, see table) whereas European countries are growing very slowly at TFRs that will ensure stagnation or shrinkage in the sizes of their population. A ranking ten or twenty years from now may show no European countries in the top 20 most populous countries.

Second, comparing European population sizes in 2014 vs. 1900 reveals a very slow annual increase in the 114 year period. And this is where the effects of the two World Wars, of the Spanish Influenza and of communism can be seen. Populations have grown with a CAGR of less than 1% per year for the last 114 years.

The United States had fewer casualties in the two World Wars, more immigration and a strong post-war baby boom, resulting in a healthy 1.3% population CAGR and a near quadrupling of the population over the past 114 years. However, as I wrote previously, the US faces slower, sub 1% population growth in the next few decades.

Here is the tally of deaths for some countries in the two World Wars:

Millions of deaths WW1 % of pop WW2 % of pop
France 1.7 4.3% 0.6 1.4%
Germany 2.8 4.3% 8.0 10.0%
Italy 1.2 3.3% 0.5 1.0%
Soviet Union 3.1 1.8% 22.0 14.0%
UnitedKingdom 1.0 2.0% 0.5 0.9%
United States 0.1 0.1% 0.4 0.3%
Click to enlarge

Source: Various. Estimates vary widely and may include errors.

Estimates of deaths from the Spanish Influenza of 1918-19 vary widely from 20 to 50 million people worldwide. And Stalin's purges are estimated to have killed over 20 million. Tens of millions of people and a larger number of descendants would have been added to today's European population had these events not occurred. I made the case last year that Europe's economies and markets suffer from weak domestic demand and have for a long time been driven by events outside of Europe itself.

Too few births

In general, a large number of countries are facing a more challenging demographic period in the next fifty years compared to the last fifty. Since the 1970s, there had been a steady decline in the dependency ratios (the sum of people under 14 and over 65 divided by the number of people aged 15 to 64) of the US, Western Europe, China and others. This decline is explained by a lower birth rate and was accelerated by large numbers of women joining the workforce in several countries. There were fewer dependents and more bread winners than in previous decades.

In future years, dependency ratios are expected to rise due to the aging of the population in most countries and a decline in the number of workers per dependent. In the United States for example, baby boomers are swelling the number of dependents who rely on younger generations to support them in retirement (whether through taxes or through buoyant economy and stock market). But because boomers had fewer children than their parents, the burden on these children will be that much greater than it was on the boomers themselves.

In effect, our demographics have pulled forward prosperity from future years. Had there been more children in the West in the 1970-2000 period, there would have been less overall prosperity during that time, but we would now look forward to stronger domestic demand and a stronger economy going forward.

Note in the table below that the dependency ratio of Japan bottomed around 1990 which is the year when its stock market reached its all-time high; and that the dependency ratios in Europe and the US bottomed a few years ago around the time when stock markets reached their 2007 highs. The fact that several stock indices are now at higher peaks than in 2007 can be largely credited to America's faster pace of innovation and to near-zero interest rates. Case in point: Apple's market value has more than tripled since 2007.

India will soon be the most populous country in the world but because its dependency ratio is still declining, its growth profile may improve in future years. The same is true of Sub-Saharan Africa where the fertility rate is still high but declining steadily thanks to improved health care for women and declining infant mortality. As such both India and Sub-Saharan Africa could see faster economic growth than elsewhere, provided the institutional framework can be improved towards less corruption and more efficiency.

Europe is in a bind in the sense that, even if it had the wherewithal to do so, it cannot now raise its birth rate without making its demographic situation worse in the near term (by raising its dependency ratio faster). For the foreseeable future, its economy will become even more dependent on exports towards the United States and emerging markets. The new frontier for European exports may well be in the old colonies of the Indian subcontinent and of Sub-Saharan Africa.

Dependency Ratios 1950 1970 1990 2000 2010 2015 2020 2030 2050
World 65 75 64 59 52 52 52 53 58
Brazil 80 85 66 54 48 45 44 46 59
Russia 54 52 50 44 39 43 48 54 67
India 68 80 72 64 55 52 50 47 48
China 63 77 51 48 38 38 40 45 64
Europe 52 56 50 48 46 50 54 61 75
Japan 68 45 43 47 56 65 70 75 96
USA 54 62 52 51 50 53 56 64 67
Africa 81 91 91 84 78 76 73 67 59
Click to enlarge

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.