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The Demographic Divide

Demographics are argued to be destiny, but much like a watched pot never boils, the change never seems to arrive. The Baby Boom are regaled as the greatest generation and have few who can counter the accomplishments. As time marches unassailably forward, they will meet the same fate that greets all humanity: age. The start of the decade marked the vanguard of this generation into retirement, and with the same economic force that drove the consumption of their halcyon decades, it also marked the commencement of an economic force that will alter the labor markets and consumption for the next generation.

While population growth contributes to economic growth in developed countries as a direct import into gross domestic product calculations, the more critical driver is the productivity growth rate of the labor force. Economic growth would be self-limiting by birth rates and, as the last two hundred years have shown, we know that people must be augmented by capital or knowledge, and optimally both. A vivid current example of this phenomenon is China, with a low birth rate and high rate of productivity growth as urbanization and capital investment permeate the economy.

Future certainty. One of the preconditions for effective forecasting is that a relationship is specified that is evident in direction and measurable in magnitude. While productivity is difficult to forecast due to the uncertainty of technology, education, and capital deployment; the change in population, specifically working age population, explicitly meet both of those objectives. The stability of demographic trends ensures that there is a 20-year lead time based on current measures of birth rates, mortality, and immigration.

The certainty of forecasting from these secular trends does provide the risk that this time is different. It is a certainty that the US work force population growth will fall to levels not seen the 1950’s when the total population was close to half the current level. Of course, never seen changes in the participation rate could occur. While the behavior of each generation is open to debate, a lifecycle approach to behavior provides a framework to support the argument that the past is prelude. The young and irresponsibility of youth leads to the obligations of middle age, and finally the luxury of retirement. The requirements of each segment of the life cycle have clear implications for economic growth.

Evolving labor force. With the knowledge that we can see the future evolution of the population in the US, we can arm ourselves with a valuable tool in assessing the future economic conditions that the US faces. The critical issue is the peak of the ratio of working population to dependent population around 2010 and the downward trend over the next few decades. This trend would not be as worrisome except that the number of people entering the workforce will slow from a previous average around 1.8 million to effectively nothing by 2028.

Two principal factors are the lead drivers of consumption: the size of the labor force and the rate of change in wages. While wealth and credit are known to contribute a little, their impact is limited. Focusing on the workforce, the expansion for this year is one-third of the amount a decade earlier. Further ahead, the expectation is that the labor force will flat line a decade from now. This outcome assumes that labor force participation rate is constant: if it were to reduce further, the decline would accelerate. The implications for trend economic growth are significant, particularly the impact on consumption expenditures.

Deflating Consumption. The effect of low working age population growth is significant for employment, consumption, and inflation in the US. The decline in the rate of the labor force growth, all else equal, results in a reduction in the natural level of aggregate GDP growth. A reduced workforce could lead to higher wages for those remaining who can then spend more; however, it doesn’t change the quantity of goods, probably just the quality consumed.

The economy could meet final demand with current levels of production capacity if demand does not grow and it would not be necessary to entice labor with higher wages. As is the case in Japan, productivity gains may offset the need to bid up labor. This outcome would leave the prime age cohort, which is slowing, as the sole driver of consumption growth.

Labor Costs. When viewing unit labor costs, the past shows that it tends to rise and fall with the workforce until recently. The result is similar when considering overall inflation: changes in the size of the workforce are primary drivers of inflation. The lower unit labor costs reflect three structural shifts in the economy:

• Reduced collective bargaining in labor contracts as unionized workers decline

• Shifting the composition of the economy to services

• Globalization that levers lower cost labor in emerging economies

Disentangling the three factors above from each is difficult as they are broadly related. The first point is a function of a more market-based economy with gains accruing to the holders of capital, while the second is an evolution of an economy from industrial to services as per capita wealth increases. More significant is the integration of the emerging workforces into the global economy that reduces the current bargaining power of developed world’s labor.

The structural shifts in the economy are enabled by the greater economic integration of countries through trade vehicles like the World Trade Organization (WTO), massive global transportation infrastructure investments, and technological advances that enable real-time logistics for multi-national corporations. Irrespective of the structural drivers, the result is that muted wage demands will reduce consumption and inflation growth as earnings gains moderate in the US for the foreseeable future.

Strategy Risk. There are arguments against the slowing of demand. The dearth of savings may force those entering retirement age to postpone retirement and can keep the labor force growing. This argument is a valid point but misses the point that they are not working to increase their spending, but either reduce debt or increase savings. The result is that extended work careers will not materially support consumption growth.

The Baby Boom generation may not be able to lever technology to its fullest as they are unable to keep pace with the change in technology. The Echo generation could provide great gains to productivity as they use their knowledge to lever technology. While we live in a time of a great change, it’s not clear that this revolution is any more significant than the prior ones where people adapted to electricity, telephones, cars, and computers.

Alternately, the nature of a service economy might preclude complete leveraging of technology over the near term. As services are more manual with ill-defined tasks, such as those found in education, health services, retail, and leisure activities, the cost of automation may be greater than the reward. Why automate haircutting when its complex, there is little improvement in speed, and labor would do it cheaper?

Even if the Echo generation can lever technology, the nature of employment with lower earnings at the beginning of the career and higher earnings at the end reflects a decline in purchasing power and slowing consumption as they replace the Baby Boom generation. Even though the composition of the labor force will change as the demographic divide continues, wages may not see a heroic rise due to these risks.

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