Is Demography Destiny When It Comes To Inflation?

My first year on earth culminated in the Summer of Love.  My 55th, and most recent year ended in the Summer of Demography. Does the trajectory the world has taken during my lifetime make me feel sad? Not at all, because – in the markets at least – demography is now sexy.  Skeptical? I urge you to keep an open mind as the reasons for demography being in vogue have very important implications for investors.

This summer economists Charles Goodhart and Manoj Pradhan published a wonderfully nerdy book called The Great Demographic Reversal. It’s causing a stir because of the authors’ confident prediction that we are headed for a world of higher inflation driven by the forces of demography. This forecast matters because if inflation rises substantially we can expect interest rates to follow and it is exceptionally difficult to justify current prices of real estate and the stock market at higher interest rates. 

Take A Breath

Don’t panic just yet. Goodhart and Pradhan are not making predictions about the next year or two. Instead, they are saying that the structural forces which have put downward pressure on inflation, and wages in particular, are gradually starting to move in the other direction. 

What are those forces? China, quelle surprise, is the most important. They claim that over the last few decades, as China’s labor force grew and was integrated into the global economy, the number of workers available for making tradable goods more than doubled. In the developed world that translated into a deflationary double-whammy – downward pressure on prices for goods and a lid on earnings for blue-collar workers in the West.

Inflation was also kept in check by demographic trends in the US, Europe and Japan. The basic idea is that dependents – kids and the elderly – are “inflationary”. They don’t earn but they do spend. In Econ 101 terms, because dependents increase the demand for goods and services but don’t supply any of them, they drive up their prices. Workers, on the other hand, are “deflationary”. They produce more stuff than they buy, especially those supporting others who are not working.

OK, Boomer.

In the last few decades we have benefitted from a “demographic dividend” – an increase in the ratio of deflationary workers relative to inflationary dependents – that has pushed inflation lower. Where did this dividend come from? Baby boomers and women. Boomers helped because, well, there are a lot of them and as they entered and moved through their working lives they increased the ratio of workers to dependents. The deflationary impact of this was amplified by the growing participation rate of women in the labor force – from about 40% in 1966 to 60% thirty years later.

Other structural forces added to the deflationary pressure. Technological improvements vastly reduced prices for many goods. We all have our stories here. The one that resonates with me is the $1,000+ I spent for a video camera when my first son was born in 1997 that did far less than the one embedded in my $300 Android phone today.  

Layered on to the welcome deflationary impact of technology was the unwelcome deflationary force of economic inequality. Simply put, rich people spend less out of their income than others. They already have everything they need, so a high proportion of their income gets saved, reducing demand for goods and services. Income and wealth inequality have grown across the globe since 1980, adding a further deflationary impulse.

From Demography To Geology

Wait, if all this is true why has inflation been around 2% per year instead of negative? Good question. Since I’m writing this in New Zealand, a country where it’s difficult to move without stumbling over a fault line, I’ll use a geological analogy to answer.  

Think of two giant tectonic plates pushing against each other.  One is deflation, driven by the forces we’ve just discussed. Moving in the opposite direction is an inflationary plate of credit and liquidity creation. Most of the time this results in a fragile balance and inflation inches forward by 2% or so each year. But while the deflationary plate is propelled by steady, long-term forces, the offsetting movement of the inflationary plate is driven by private sector risk taking, which occasionally shuts down. 

When this happens, like in 1998, 2008 and 2020, the balance is suddenly disrupted and we have a deflationary earthquake. At that point, central banks step in with lower interest rates and asset purchases. This halts the deflationary surge, eventually starts the inflationary plate back in motion and restores an ever more fragile balance. For those interested in the details on how this world works, I co-authored a book in 2019 called The Rise Of Carry that describes it in detail.

The Great Demographic Reversal predicts that the deflationary plate will start moving in the opposite direction, exposing the economy to its first inflationary earthquakes since the 1970’s. Why? Baby boomers are starting to retire and low birth rates mean they aren’t being replaced.  Meanwhile, the downward pressure on wages produced by the integration of China into the world economy is over. 

And new inflationary forces are emerging. The transition to a low- or zero-carbon world will increase measured inflation, at least in the medium-term. In addition, the U.S. government is running it’s most expansionary fiscal policy in thirty years despite an economy that may hit full capacity next year. Lastly, in the wake of Covid de-globalization is seen as a way to make critical supply chains more robust to another pandemic. Add all this up and it’s not hard to imagine the inflation plate getting the upper hand.

Some Think Low Inflation Will Continue

Not everyone agrees with this picture. Those who disagree point out that technology will continue to lower prices. I agree in principle, but when I look at the sectors that society cares the most about – health and housing – I still see the demand for human work outstripping technology’s ability to automate and reduce costs. 

With more retired people living much longer, an increasing fraction of the economy will be devoted to care. Sure, some aspects of this will be automated, but will you really want robots dressing, feeding and explaining Tik Tok to your elderly parents? 

Housing feels similar. The lack of housing affordability is rapidly becoming an existential problem for advanced economies. Vast numbers of houses need to be built and will be built. Will that be less labor intensive than in the past? Absolutely. But housing is not just about putting up four walls and a roof – you need electricians, plumbers, flooring people and, for those so inclined, an array of advisors on things like color, fabrics and spice racks. On balance, I don’t see technology’s deflationary effect as being enough to offset rising wages in these types of sectors.

The other counter argument is that inequality matters more than demography. Economists Atif Mian and Amir Sufi, who authored an exceptionally readable book on the 2008 crisis called House of Debt, have recently published a paper where they argue just this. They agree that an ageing society on it’s own can cause more spending (and therefore be inflationary) but they think this is swamped by inequality, which has the opposite effect. 

The question then becomes – will inequality continue at current levels or decline?  The Great Demographic Reversal argues that the key driver of rising inequality was the extraordinary surge in labor availability that held down wages and, as this wanes, so too will inequality. Even if this isn’t true I see a political consensus developing that means some form of wealth redistribution is inevitable

Stop, Drop & Roll

The financial markets have experienced some scary earthquakes in the last few decades. Scary, yes.  But also understandable – deflationary forces suddenly became ascendant until more inflationary firepower was provided to stabilize the system. 

We’re now in a transition period where this type of deflationary disruption is still possible, but so is a sudden burst of inflation as well. Longer-term, as new demographic trends take hold we can expect inflationary earthquakes to dominate. I know – another thing to worry about. But the first step in navigating risk is to understand it and that’s why we all need to show demographers a little love.

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