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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!

Source: A Demographic Headwind for the U.S. Dollar