Arnott: Demographics And The New Normal

September 10, 2013

A look at some head winds to recovery.

Editor's Note: This article was originally published in the September/October issue of the Journal of Indexes.

Much recent demographic research focuses on prospective head winds that may impede macroeconomic growth and impair capital markets returns relative to historical norms. But almost all of this work, including our own past efforts, raises the question, What's normal?

Modern historical "norms" were far from normal: The past half-century-plus has enjoyed a substantial demographic tail wind, which some call a "demographic dividend." Support ratios tied to our children tumbled, and support ratios tied to our parents and grandparents are only now beginning to soar. In this paper, we seek to quantify that tail wind: How much of the impressive macroeconomic growth of the past 60 years can be attributable to unusually benign support ratios?

In studying past and future demographic trends, we discover that the coming head winds may be more serious and nuanced than previously thought. Our findings show that we'll first experience a strong "demographic tax" as our senior citizen support ratios soar. Until we reach a new—and highly speculative—"steady state," with births equaling deaths and with fertility ratios matching the "replacement rate" of about 2.1, economic growth rates are likely to be abnormally low.

We offer the cautionary note that these new demographic profiles are so profoundly "out of sample," relative to anything in the historical data, that our conclusions have to be viewed as somewhat speculative. The good news is that slower growth with high prosperity is much better than faster growth with low prosperity; all we need to do is adjust our expectations.

Four Demographic Phases
In this paper, we show that the historically unmatched economic performance experienced by developed countries over the past 60 years was supported by temporary and abnormal demographic conditions: extraordinary growth in the working-age population supporting both a plunging roster of young people as well as a still-modest roster of senior citizens. In other words, we have experienced a one-off demographic dividend of massive proportions.

Our work invites two important questions: As developed (and emerging) countries age, what do future demographic profiles look like? And what should we expect in terms of economic growth when there is no demographic tail wind?

In the first half of the paper, we try to answer the first question by describing four phases in the role of demography on macroeconomic development:

  • The first phase, covering most of human history on the planet, was a high-mortality steady state, with births roughly matching deaths, short life spans and lofty support ratios.
  • The second phase, beginning roughly with the industrial revolution and building to a crescendo in the decades after the Great Depression and the Second World War, was characterized by a steady rise in life expectancy and drop in birthrates. The working-age population soared, concurrent with a tremendous drop in support ratios (the number of nonworkers, young and old, supported by the labor force).
  • The third phase, beginning in the current century, is also temporary and almost a mirror image of the second phase: The fraction of seniors soars and the fraction of workers tumbles. Until fertility rates return to replacement levels (roughly 2.1 children per woman of child-bearing age), the population crests and begins to drop, with very high support ratios associated with senior citizens. We show that this should not come as a surprise, because both phases (II and III) share the same sources: rising life expectancy and falling fertility ratios.



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