This is going to be wonkish, but it’s important–so bear with me. I’m going to talk briefly about the EU’s new turbocharged quantitative easing policy announced on Thursday, but from a very different angle from the news reports. But to start with, let’s look at a chart from Japan (click for larger image). Why? Because, demography-wise, Japan has already got to where most will soon be–or rather it is a couple of steps ahead.
The chart is taken from a wonderful (at least for me) publication from the Japanese Ministry of Finance called “Japanese Public Finance Factsheet“. As you can see, we have two pigs making their way through the python: 6.5 million just retired baby boomers and 7.9 million second baby boomers–the offspring of the original baby boomers.
Next a crash course on the components that make up an interest rate. These include the risk free rate, expected inflation, default risk, liquidity risk and maturity risk (often called the term premium). When you buy debt in a country’s own currency, the default risk is generally minimal (the government can tax or even, ultimately, print more money to pay its debts). Moreover, government bond markets have huge volume, so your liquidity risk (your ability to sell whenever you want) is also not an issue. The maturity, or term, premium is a bit more technical, but its pretty small so I shall put it to one side.
So, simplistically, we can focus on the risk free rate and expected inflation rate when considering government debt (and the interest rates on government debt is the reference point for interest rates on all forms of debt). What’s this got to do with the above chart? A lot, because every introductory text book is based on the axiom that individuals will prefer to consume something now rather than consume it tomorrow. Put another way, the risk free rate is the price an individual (more formally individuals in aggregate) demands to defer consumption. It’s a kind of anti-hedonism bribe.
Now look at the above chart again. What do you think those just-retired baby-boomers are most worried about? I hazard a guess that it is maintaining an adequate level of consumption into old age. Do they need to be bribed? No, they are scared witless that they will be destitute in old age anyway. In particular, Japan’s government debt mountain must produce a visceral fear: the elderly know that their future spending power will be subject to continued assaults from either tax rises (such as consumption tax hikes) and/or cuts to welfare spending. They may not know when these things will happen, but they know they will happen,
How about the second generation baby boomers? While only in their 40s, they see ahead of them a huge phalanx of the elderly that will need to be supported by taxes on them. Moreover, they are working within an economy that has seen meagre growth and falling median real wages. Put bluntly, they are also scared witless about having any spending power in their old age too.
So for these key demographic cohorts in Japan, the real interest rate is likely to be zero. Indeed, I think for many it may be negative; that is, a lot of Japanese would be willing to handover one million yen now if they were guaranteed to get 900,000 yen of consumption (in real terms) 10 years down the road. No economics text book sees the world that way, because no economics text book takes into account the never-seen-before demographic patterns of the present day.
What happens if we introduce some inflation? This is what the Bank of Japan Governor Hiroki Kuroda has vowed to do. Indeed, he has undertaken to continue with unconventional monetary policy until 2% inflation is achieved. His aim is to force consumers into buying something now since it will cost much more in the future. And, indeed, this is what happens in the face of consumption tax hikes. However, consumption tax hikes are one-off events, and, after each hike, consumption falls back down to where it starts. So to get consumers to repeatedly bring forward consumption you need to achieve consistent and ongoing inflation.
Now if the economy were merely made up of durable goods, this strategy may work. But what goods and services are the just-retired baby boomers most worried about securing in old age. It certainly isn’t that most durable good of all, housing, they already have that need covered (and if they don’t, it’s too late now). Obviously, the biggest concerns are home care and medical expenses–and you can’t pre-consume these. Similarly, those 40-year old baby boom echoers may wish to upgrade their cars, but they are mindful of the black hole in the Japanese government’s finances–so all spending decisions will be ultra cautious.
Strangely, in the face of rising inflation expectations–and with no investment available that has a return that will match those inflation expectations–a prudent person may logically decide to cut back further on current consumption in order to have any chance of maintaining a dignified standard of living in later life. This means demand will remain flat and for some even fall, and so the expected inflation never actually makes the transition into real inflation. In short, QE does not dig the country out of a deflationary hole.
And so to Europe. From the above chart on Japanese demographics, we can extract an old age dependency ratio; that is, the number of people over 65 divided by the number of people in the working age band of 20-64. For 2014, this was estimated to be 46%, for 2025 it is projected to be 56% and for 2040 is forecast to be a pretty stunning 72% (seven elderly per 10 working age).
For Europe, I’ve constructed the following chart (click for larger image) from Eurostat data (here) concentrating on the Big Three eurozone countries and the so called PIGS (Portugal, Ireland, Greece and Spain). I’ve also thrown in the non-euro UK for good measure.
The ratios in Europe are calculated a little differently, since the working age population is defined as 16-64 as opposed to 20-64 for Japan. Accordingly, if you put the Eurostat numbers on a like-for-like basis with the Japanese numbers, they would be a couple of percentage points higher. However, the message is the same: Europe is on the same road as Japan, just a little behind. Moreover, some of the most economically troubled countries, such as Greece and Portugal, are furthest along that road.
My bottom line: the EU’s new monetary policy, which aims to slay deflation by dragging consumption forward, may prove as ineffective as it has in Japan. Very sensibly, many households don’t want to consumer now, because they fear they won’t be able to consumer later, in old age.
I also think these dependency charts raise some deeper questions over the nature of consumption, growth and happiness itself. Most studies of happiness show the over 60s scoring highly. Their need for so called positional goods using the sociology definition (goods that confer status) appears more muted. The advertising industry thrives on the idea that happiness is derived from both what we consume now relative to others and what we consume now relative to what we consumed in the past.
In an aged society, such constructs of happiness appear less relevant. Indeed, if the elderly can detach happiness from rising income, consumption and, by extension, economic growth, why can’t everyone? Unfortunately,the monetary authorities of both Japan and the EU don’t appear able to recognise this fact.