A Demographic Headwind for the U.S. Dollar

What if we had a time machine that could tell you how the world markets and economies are going to behave? We do – it’s called demographics. While this time machine won’t tell you the winner of the Super Bowl in 2015, it will tell us a lot about the probable behavior of world economies, consumer behavior and investment and saving preferences.

We all know about the Baby Boomers in America. The appearance of this cohort has dramatically affected American consumer and investment behavior for the last half of the 20th Century and will do so into the 21st Century.

There are other “baby booms” that have occurred around the world. Japan is the oldest. It had a baby boom whose demographic peak preceded the US one by about ten years. The US, Canada, Australia and New Zealand had a post WW-II baby boom all about the same time. The EU also had one, albeit with lower intensity, that lagged the US boom by about ten years.

Poole’s projections for Japan

With that in mind, we can roughly forecast what America will look like by looking at Japan and lag it by ten years. William Poole, the former president of the St. Louis Fed, gave a paper in 2005 analyzing the probable demographic effects on the Japanese economy. He argued that with her aging population, Japan’s trade balance will slide inexorably into the red (see graphs here). Left unsaid is the pressure on the Yen as Japan’s current account deteriorates.

Japan is known to have a very high savings rate. With American savings rates so low and the US current account in severe deficit, what will be the probable path of the US Dollar once this demographic storm hits?

China saves the world, but…

Laurence Kotlikoff is an academic that has written extensively on demographics and their effects on the economy. In a 2005 paper entitled Will China eat our lunch or take us to dinner? he wrote that all is not lost because China can save the world:

If successive cohorts of Chinese continue to save like current cohorts, if the Chinese government can restrain growth in expenditures, and if Chinese technology and education levels ultimately catch up with those of the West and Japan, the model’s long run looks much brighter. China eventually becomes the world’s saver and, thereby, the developed world’s savoir [sic] with respect to its long-run supply of capital and long-run general equilibrium prospects. And, rather than seeing the real wage per unit of human capital fall, the West and Japan see it rise by one fifth percent by 2030 and by three fifths by 2100. These wage increases are over and above those associated with technical progress, which we model as increasing the human capital endowments of successive cohorts.

However, this doesn’t mean that the developed world is out of the woods:

On the other hand, our findings about the developed world’s fiscal condition are quite troubling. Even under the most favorable macroeconomic scenario, tax rates will rise dramatically over time in the developed world to pay baby boomers their government-promised pension and health benefits. As Argentina has so recently shown, countries can grow quite well for years even with unsustainable fiscal policies. But if they wait too long to address those policies, the financial markets will do it for them, with often quite ruinous consequences.

How ruinous are the consequences for the US? Here are some current options that he suggests:

- 70% increase in personal and corporate income taxes;
- 109% hike in payroll taxes;
- 91% cut in federal discretionary spending; or
- 45% cut in Social Security and Medicare benefits.

While you ponder those questions - Happy 4th of July!

Comments

[PastTense:]

It's already clear what the United States is going to do:
1. Cut Social Security benefits via Statistics (it's clear no one outside the government and media currently believes we have less than a 4% inflation rate, the government will continue this process of re-defining the CPI)
2. Print money.

2008 Jul 03 03:59 PM

[dieuwer:]

¨70% increase in personal and corporate income taxes¨
¨109% hike in payroll taxes¨

Both will lead to massive job losses and strikes, if not revolution.

¨91% cut in federal discretionary spending¨

If you scrap the president, sure...

¨45% cut in Social Security and Medicare benefits¨

You wanna mess with granny? Be carefull...

2008 Jul 03 04:38 PM

[bbzz24:]

i doubt it china will save the world. after all, are they so stupid to lend money to a retired bunch that has no savings? who is going to repay them?

2008 Jul 03 04:43 PM

[David Jackson:]

Isn't this a bigger problem for Europe and Japan than the U.S? Look at this:
seekingalpha.com/marke...

2008 Jul 03 05:19 PM

[mkreisel:]

Let people work to death then.

But on the other hand, if the US is in trouble, what's the outlook for Europe, Japan, and Russia then? Heh, even China will soon reap the fruition of its "One-Child Policy".

2008 Jul 03 05:23 PM

[whidbey:]

The nature of Chinese national wealth has been to date the low costs of manpower, making the labor reserve in China a potential capital, but it is not necessarily so that China's human capital will be enhanced in each cohort. To do that China must upgrade its basic sciences, eduction, and infrastructure for innovation. China has more Potential Human Capital, but it will not be stable and productive without free enterprise (today largely sub rosa), political freedom (nil), a modern banking system (farce), working international relationships with trade partners (WTO membership is only the first step), and a currency that is freely exchanged and not manipulated.
China has yet to prove itself, or define its role.

2008 Jul 03 05:25 PM

[aquaculture:]

Dear mr. Hui: It is my experience that almost all economists (Kotlikoff no exception) continue to model technical progress in an intuitive linear fashion, while the history of technology shows such progress to be EXPONENTIAL.
kurzweilai.net/article...

Should you still not be convinced i would be happy to both defend the dollar and refute the Kotlikoff hypothesis.
Happy 4th July

2008 Jul 03 06:55 PM

[cook503:]

Can we please reform Social Security now?

2008 Jul 04 02:02 AM

[Badgolfer:]

Did the authors mentioned deal with the disastrous birthrates in Europe ? The US rate is currently 2.15 and the only developed nation at maintenance level.
Did they figure in the world lead of the Japanese in robotics ? In 2043 a team of robots expects to defeat the human World Cup Champions.Don't bet against them.

2008 Jul 04 08:37 AM

[nukldrager:]

Badgolfer see David Jackson comment w/ link, good point.
As for robotics, nano tech, etc... we ain't seen nothing yet

2008 Jul 04 11:08 AM

[kmne68:]

Immigration is our best hope. Let's keep it legal and bring on the Mexicans, Indians and Chinese. It would help Europe too if they would make the islamic extremists conform to western standards rather than bowing to the Sharia-bound masses.

2008 Jul 04 01:43 PM

[carey_jim:]

Predicting the future is a futile but necessary human activity.

Las Vegas and the Stock Market are both shrines to that necessity.

Will global warming happen in the future?

If we can't agree on that hugely important event, how will we be able to agree on the future of the world economy?

2008 Jul 04 02:58 PM

[Kunst:]

*Can we please reform Social Security now?"

You mean like 1950, or 1960, or 1970, or ... ?

It's a Ponzi scheme. Eventually it will collapse.

2008 Jul 05 12:03 AM

[borisb:]

Yes SSI benifits are adjusted 2% per year, while energy, grocery, healthcare, education nearing 10% per year. scam!

2008 Jul 05 07:12 PM

[huangjin:]

Social Security is easy. Whatever it takes in is what it pays out; cut benefits and raise the retirement age. Medicare is the bigger problem and will require rationed care. People will scream, but ultimately the taxpayers have the power because they pay the bills.

2008 Jul 07 09:44 AM