Saturday, June 09, 2007

The Nature of the Fertility Trap?

We have certainly been devoting some time here recently on DM to the discussion of the potential drivers of any possible fertility trap which may arise as the TFR of a country drifts below the 1.5 threshold. As a derivative of that debate the discussion also briefly moved over to Alpha.Sources where also the author of the Ape Man blog contributed extensively. Indeed, Ape Man* got so interested that he wrote a large essay in response to my and Edward's musings on the potential drivers of any possible fertility trap. Below Demography Matters would like to present a large extract from this essay. This is being presented here at DM in the form of a guest post, and we do this in the spirit of our emphasis on open debate and the exchange of ideas.

Ape Man has taken the trouble to try and argue against a view that Edward and I have been presenting: namely that societies as they age will increasingly pass through a stage where they become export dependent. Since most commentators seem simply to ignore this issue, an attempt to prove the idea wrong is certainly a welcome contribution to the debate. This, at least, is progress.

Does an aging demographic structure lead to an export-oriented economy?

By Ape Man

As part of their work on the Fertility Trap Hypothesis, Edward Hugh and Claus Vistesen argue that an aging demographic profile will lead to an export-oriented economy . More controversially (at least to me), they argue that a move towards an export economy will make it hard to raise birth rates to replacement levels. They think that the process of moving towards an export-based economy will put pressure on wages of young people which in turn will make them less likely to have children.

Mr. Hugh and Mr. Vistesen's argument revolves around the Life Cycle Model of consumption and savings. The special twist that Mr. Hugh and Mr. Vistesen bring to the idea of the Life Cycle Model is that it can explain things on a macro level based on the demographic profile of the country in question.

Now there are many ideas in the Fertility Trap Hypothesis that I think are quite strong and likely to hold up across all cultures. But I don't think that Hugh and Vistesen's work with the Life Cycle Model will be one of the successful ideas. I see no reason to think that fertility will be negatively affected even if savings/consumption behaves as the Life Cycle model says that they will. In other words, even if the Life Cycle Model holds true across all cultures (a big if, that), the economic effects that will result are not part of the "Fertility Trap."

It's a little bit cheeky for me to say all that. After all, Mr. Hugh is macroeconomist with many years of study. And though Claus Vistesen is still a student, he has done far more studying on this matter than I have. By comparison, my background as an ignorant hillbilly means that my credentials are a little thin for tackling such issues as the Life Cycle Model of consumption and savings and how it relates to demographic age structures on a macro scale.

But Mr. Hugh's response to a comment I made over at Vistesen's blog has stirred up my thinking on the issue. So in between trying to get over sinus issues (otherwise known as the common cold, apeman style), trying to fix my truck, and trying contribute my fair share towards getting a garden in, I have been pondering Mr. Hugh's and Mr. Vistesen's idea.


So what is my problem with Hugh and Vistesen's idea? It seems so far our little thought experiments have supported their contention that an export-oriented economy is a natural feature of an aging demographic. But that is only half of Hugh and Vistesen's idea. The other half of their idea is that this process would lead to lower wages for young people and thus discourage them from having children. The idea is that this process is self-reinforcing. This is why they want to add it to The Fertility Trap Hypothesis.

This is where I get lost. No matter how I run my little nomad model and no matter what other models I try to create, I simply can not understand why this process should lead to lower incomes for young people. In fact, most of my thought experiments seem to indicate that if any thing, wages for young people should rise.

Now, that is not to say that I can't see other ways that an unbalanced demographic would put downward pressure on wages for young people. Higher health care costs associated with an aging demographic and a universal health care system would be one such example. In that system, cost would be spread over all the workers, but the benefits would be going primarily to the elderly. The effect of this would be to depress the wages of young people relative to wages of previous generations of young people.

But Hugh seems to think that the changing mix of consumption and investment associated with an aging demographic would negatively affect young people. He says….

In order to compete for exports these economies have a permanent pressure on their tradeable sectors, whereby outsourcing is continuous and ongoing, wages are continuously compressed, and structural reform is permanent. Since the very export dependence is only further reinforced by the continuing process of change in the population pyramid (ie domestic demand never "recovers" as such) this is all self-reinforcing. That is the more time passes the more there is downward pressure on the wages of young people.

In a different post Vistesen says…

And this dear readers is where demographics come in and more specifically why we need to look at the population structure of for example Germany and Italy in order to really understand what is going on before our eyes. Why for example is consumer spending persistently low in these two countries and why is Germany running a trade surplus of 6% of GDP.

The common theme in Vistesen's and Hugh's argument seems to be that an ageing demographic will consume less as a percentage of their income and thus younger people will have less job opportunities. But as far as I can puzzle it out, even if you grant their premise, their conclusion does not follow.

Let us go back to my nomad model for a bit. If my little nomad group ships out sheep in return for promises of future support, that is going to reduce the amount of lambs that they are going to get in the coming spring. Less sheep=less lambs.

But this is not necessarily a loss. If you have more sheep than you can efficiently take care of (which is why they want to send sheep away, remember?) then you might have less lambs the following spring anyway. Thus you might not necessarily be losing lambs by sending sheep away.

Now I think that this applies pretty well to a modern economy. All other things being equal, those nations that export capital are going to have a slower growth rate than those who import it. True, you expect to get a return on that exported capital. But in the short term, that return is only a fraction of what you paid out (i.e if you get a 7% return on your money, it is going to be a while before you get your hundred dollars back).

Thus I can accept nations that run trade surpluses will have slower GDP growth than those that don't (all other things being equal). And I accept that slower GDP growth means less job creation (all other things being equal). But how is this a problem for a demographically challenged society?

The problem that leads a demographically challenged society to export capital is that they don't have very many young people. That means they don't need to create very many jobs. But that does not mean that the jobs that they do create pay less. In fact, given that young people have a competitive advantage at many tasks, one would think that a shortage of young people would actually cause their wages to rise. (Granted, older people have a competitive advantage at many tasks as well. But there would be an abundance of them.)

In short, domestic consumption does not have to be as robust in order to provide sufficient employment for the younger cohort in a demographically unbalanced economy.

Hugh argues that trade puts pressure on wages. So, by his reasoning, when you work in exports, your paycheck is always under pressure. I am skeptical of this line of reasoning, but even if it is true that working in exports puts pressure on wages (which does not seem to be the case from what I have read), this is not really an issue related to demographic saving patterns. One would expect that if people in other countries could make something cheaper that it would affect the wages of young people regardless of whether the demographic profile was aging or not.

Hugh and Vistesen's strongest point in their favor is the real world data showing that incomes for younger people have dropped when compared to their parents at a similar age. But this is very misleading data.

The proper data for Hugh and Vistesen to base their claim on would be to compare the total cost to the employer of each hour worked by the younger generation and the older generation at a similar age. I strongly suspect that with the rise in pension costs, health care costs, increased labor regulations, and greater vacation time, that you will find that young people around the world are costing their employers more than their parents did at a similar age. I suspect that this would hold true in Japan and Europe in particular.

To be sure, this does not take away from the fact that young peoples' wages are dropping. And the fact that their wages are dropping could very well be a contributing factor in the lowering of fertility rates. But if young people are costing their employers more than their parents did at a similar age, then I think that you can hardly blame an export-oriented economy for putting pressure on their wages. Instead you must look to those things that are causing their labor to be so much more expensive than their parents at a similar age.

The long and the short of this is that I can see an aging demographic profile leading to a trade surplus. But I don't see this as being something that contributes to "The Fertility Trap." Rather I see it as the last hope of many countries to get out of the "The Fertility Trap." And as the world ages, that last hope is going to fade fast.


*(Mind you, Edward and I are referred to as Mr. Hugh and Mr. Vistesen which of course makes the identity of Ape Man somewhat off in comparison, but that is nevertheless the name our friend here goes by in the blogsphere, and as such we naturally respect his wishes. Maybe it is just coincidence, but isn't there some relation somewhere between Bonobos and our earliest ancestors.)


Edward Hugh said...

Hi AM,

First off let me thank you for taking the trouble to write this, as Claus has said your contribution obviously forms part of the intelligent and reasonable debate that we think is very much needed given the fact that all these things we are talking about are more or less new, and as such there is no evident "knee jerk" response.

As you explain there are evidently two issues at stake here:

a) the structural characteristics of mature economies as populations age

b) whether or not such structural characteristics re-inforce a fertility trap (should one exist).

Despite the fact that the debate here has revolved around (b) I would prefer at this point to focus on (a), since if these are not clear then it is hard to apply findings to a hypothetical case of (b).

Reading through your post I am struck by this:

"But if young people are costing their employers more than their parents did at a similar age, then I think that you can hardly blame an export-oriented economy for putting pressure on their wages."

and this

"More controversially (at least to me), they argue that a move towards an export economy will make it hard to raise birth rates to replacement levels."

and this:

"They think that the process of moving towards an export-based economy will put pressure on wages of young people which in turn will make them less likely to have children."

Now I think we may be arguing slightly at cross purposes here, and I suspect that I have part of the responsibility for this, and in particular in the light of this that you quote from me:

"In order to compete for exports these economies have a permanent pressure on their tradeable sectors, whereby outsourcing is continuous and ongoing, wages are continuously compressed, and structural reform is permanent."

The reason I think this is misleading is that this pressure on the tradeable sector is not something that I consider at all to be harmful, indeed I think it is positive, in that it means that productivity in these sectors is liable to be high, and, for example, I think that part of the reason that Italy is having so much difficulty at the moment is that it has not been able to respond to this challenge, and isn't able to generate exports in anything like the way Germany is.

But the real point is this:

The issue isn't that an export oriented economy is a bad thing, but rather why these societies come to rely on exports in the first place. That is I think the causal arrows may run the other way round than the ones you are imagining (and if it is like this, then as I say, I suspect the fault is entirely mine).

The issue is one of internal demand. Basically what we are arguing is that there is a mechanism in operation - via the generation of new credit - whereby societies with fewer people (as a proportion) in the 30 - 40 age group tend to generate less debt dependent consumption, this means that with some small increase in productivity domestic output can grow at a more rapid rate than domestic consumption, and it is this that puts the downward pressure on prices (and thus on wages). Domestic demand simply doesn't grow quickly enough (and hence, I think, in part the deflation phenomenon in Japan.

I have just put together a whopper post on some of all of this in the Italian context here, where I try to look at housing as an archetypal services component, and migrant flows, in order to try and contextualise Italy's problems.

Whoops, time has run out. I have to run to be somewhere else. More later.

Anonymous said...

I got twenty tons of wood to cut today so I can't respond right now. But I would like to point out that I did not try to "prove" you guys wrong. That would require data. All I did was try to puzzle out an understanding of your idea and I hit a brick wall in the process. Talk to you later…..

Edward Hugh said...

Hi again, I'm back. And first off careful with the wood, since at times this can be risky work. I know, since I have done some myself.


"That would require data."

Yep, I think you are right here, in the sense that what you want to do is examine your model, and this you should be able to do in the abstract.

Basically I think your model of sheep and nomads captures quite adequately the idea of different societies passing through their demographic transitions at different rates, with some able to run trade surpluses while others run trade deficits.

But on this level there is one point that I would draw attention to, and it is this one:

"This implies that there must be economies that can handle the extra capital"

The problem is only, or even principally one of capital, but also of product, these countries need to sell an increasing portion of their GDP externally in order to maintain some sort of level of economic growth.

And this raises an additional issue which your model can't quite capture (I don't think) and this is why is it that export dependent societies need to grow in the first place. I mean couldn't they just sink with dignity?

The problem comes from the existence of growing dependency ratios and the fact that some part of the responsibility of maintaining the retired population depends on the younger generation.

In order to fund this, your economy needs to grow. If you don't achieve this growth either your state runs up deficits (as in the Italian case) or you have to reduce anticipated benefits, and this, as Claus points out somewhere, tends to lead to even more saving among the younger age groups.

Now quite why all of this leads to downward pressure on wages is a mute point, and you are probably right in arguing that this (theoretical) issue is one of the tricky points in the argument.

Essentially, as age structures change, labour should come into short supply, unemployment fall, and the relative cost of labour rise. Good old neo-classical theory should lead us to expect this.

But - and this is where I need to appeal to the real world - this is just what we are not seeing happening in Japan, Germany and Italy. Unemployment is falling steadily as the labour market tightens, but wages are not rising, or not rising above the rate of general inflation (in Germany they have trended down in recent years, and in Japan they are still falling, only in Italy is the situation mixed, and this may well again be another symptom of the Italian problem. Wages in the private sector rise more slowly than inflation, but they continue to rise in the public sector).

Now quite why this should be the case is something of a puzzle, since as I am saying it seems to go against neo-classical expectations.

I can think of two evident factors. The first is, obviously, weak internal demand, which puts strong pressure on companies in terms of the prices they can charge and, indirectly, the wages they can pay.

The second, is in fact the one I was trying to get at but expressed badly in the comment which caught your attention, and that is that in the export sector there is a constant pressure to make structural changes to maintain growth, and this may not produce lower wages, but rather losses in core employment with workers being displaced into other, less productive sectors. This would be part of the Bazaar economy idea put forward by Hans Werner Sinn in the book Thomas draws attention to in the last post.

Obviously this is a complex topic, and in particular it is made more complex by the fact that apart from inputs and outputs you need to take into account relative prices (or general equilibrium factors, which is what makes macro-economics such a difficult thing IMHO).

Undoubtedly there is a lot more that could be said, but maybe this will get us started.

Edward Hugh said...

Hi again,

Looking through the German Federal Statistics site this morning I came across this recent data release.

What is most revealing is the fact that the index of gross wages and salaries has been steadily declining since the turn of the century.

Looking at the evolution year on year we can see in the first quarter of 2007 the costs of an hour worked in industry and the service branches as a whole rose by a calendar-adjusted 0.4% against the same quarter a year earlier.

This is frankly interesting for a number of reasons. In the first place Germany is the classic case of an export dependent economy, and secondly the German economy grew at a very strong rate in 2006 in comparison with recent performance.

Now I am *not* saying that this evolution in hourly wages *caused* by export dependence, but I am hypothesising that it may be associated with the same structural complex which leads Germany to need to depend on exports.

If this is right - and the precise explanations still need to be identified - then we have a process of 'wage squeeze' which may well be exercising a negative influence on the fertility decisions of young people, and this, I think, is all that Claus and I are really saying.

Data from Japan are not disimmilar, and it now remains to be seen how Italy evolves given the fact that increasing government spending (and hence increasing wages in the public sector) would now seem to be very constrained by the fiscal and debt dynamics which Italy faces.

Italy is not yet, of course, an export dependent economy - in fact with high energy costs it has been running a trade deficit - but it *should* be, since domestic consumption growth is very weak, growth generally has been very low, and as a consequence the government debt (currently at 107% of GDP) has been ballooning in a way which is clearly not sustainable.

Anonymous said...

I need to think things through for a period of time before I am able to say anything of worth. So I don't expect I will be able to make a reply worthy of Mr. Hugh's comments for a while yet. But I will be so bold as to offer up some comments based on my first impressions.

For starters, I agree that falling real wages for young people in the face of an aging demographic is a problem that needs to be addressed. Considered from a purely theoretical stand point, this is not the result that one would expect. I am just not sure that you are on the right track as far as the cause of this phenomenon.

As I said in my post, most measures of wages are based off what an employee receives not what an employer has to pay out. To give a crude example: in my area a decently paid administrative assistant (used to be known as a secretary) will make roughly as much as a roofer. But the roofer costs far more to employee than the secretary because of worker's comp costs (mandatory insurance that employers are required to have in America).

As an aside, this is why so much roofing work is done under the table in America. Roofing work in grey economy is extremely lucrative because then the workers can pocket the money that would have gone to worker's comp. Thus, done off the books, roofing allows big money to be made by people with little education. On the other hand, roofing work done on the book is a dangerous job that does not pay much better then jobs that have similar educational requirements to roofing and require sitting at a desk in an air conditioned room.

When I look at how many regulations, insurances, and legally mandated time off that employers have to provide/comply with these days, I can't but help think that they are a big part of falling wages.

Another common problem with studies showing that young people make less then their parents did at a similar age is the lack of allowances for the effects of immigrants. Most immigrants are very young and poorly educated. To use them as proof that wages for young people are going down does not prove much.

Also, I can't but help think that cultural changes play a part as well. I don't think that the current generation works as hard their parents did. The unprecedented prosperity that the Western world has seen over the last fifty years has weakened work ethics. Last I read, this could be proved empirically in some countries (such as Japan), at least in terms of hours worked.

Until I see a paper rigorously controlling for these effects, I am going to remain unconvinced that we need an explanation for falling wages that goes beyond those factors.

More broadly, I suspect that my main problem with Mr. Hugh's train of thought centers around the idea that he expressed here….

The problem is only, or even principally one of capital, but also of product, these countries need to sell an increasing portion of their GDP externally in order to maintain some sort of level of economic growth.

I don't want to be to dogmatic about this since I have not had a lot of time to think through Mr. Hugh's argument, but I suspect that he and I differ on the nature of a trade surplus.

Mr. Hugh seems to see a trade surplus as a vehicle for creating economic growth in the absence of domestic demand. I see a trade surplus as something that trades current domestic demand for future consumption. Let me explain.

Presumably we can all agree that a trade surplus is when one country exports more goods and services then it receives.

What does a country acquire by dong this? Again, I think we can all agree that it acquires foreign stocks, bonds, factories, and the like. In other words, a trade surplus represents an investment in foreign capital (the one exception here would be payments for tourism).

Now what is the difference between capital and consumables? The primary difference between capital and consumables is that capital contributes to future growth (or at least we hope it will) and consumables don't.

So far as that goes, I presume Mr. Hugh would agree with me. After all, it is pretty standard stuff in the field of economics.

But I take these standard assumptions and reason out a different conclusion then Mr. Hugh. For starters, I take a trade surplus as a sign that there is an appetite for a rate of return that cannot be met by the domestic economy. My reasoning is thus…

A trade surplus= the acquisition of foreign capital. So we must ask, if people want to invest in capital why are they investing in foreign capital? The natural answer is because they want a higher rate of return. Why do they want a higher rate of return? Because they are looking for increased future consumption.

Thus a trade surplus represents an investment in another country's growth at the expense of the domestic economy in the hopes of increased future consumption.

Now, I thought that was pretty standard, but Mr. Huge (who has far more extensive knowledge of economics then I) seems to look at trade surpluses primarily as driver of employment. To my mind, though, any gains in employment because of a trade surplus are more than offset by the loss of investment in the domestic economy. All other things being equal, I see a trade surplus as being a brake on domestic economic growth and a trade deficit as being an accelerator for domestic economic growth.

How then would I explain the contrasting economic growth between Italy and Germany? After all, Germany has a trade surplus and economic growth where as Italy has a trade deficit and has very little growth.

My answer would be contained in the little wiggle room provided by the phrase "all other things being equal." More precisely, I see the key to economic growth as being return on domestically invested capital. To my mind, this is be all and end all to economic growth. That is why I think that running a trade surplus reduces potential growth.

But there are other ways of lowering the domestic return on capital besides running a trade surplus. You could also spend it on poorly conceived government project. This would lower future growth even more then running a trade surplus. At least with a trade surplus you can look forward to future return. On the other hand, wasted money can never be recovered.

I won't elaborate much on this point for now. I would just like to note that Italy's public debt as a share of GDP 107.8%. Germany's public debt as a share of GDP is 66.8%. It is hard to export capital if your government is sucking it up like a sponge.

Also, I would like to note that if you cut northern Italy away from southern Italy you would have a country that behaved just like Germany.

The key to Italy's failure is not that it does not run a trade surplus, but that it has a higher dependent to work ratio then Germany does. Especially if you count the people involved in make work projects as being dependent.

Even though this comment was rather long, it is simply the result of my initial reaction to Hugh's comments. As I said in the beginning, I need to think on Mr. Hugh's response longer in order to give a more coherent and well thought out response.

CV said...

Hi you two,

There has already been much ground covered here so I am not quite sure where to start.

One of the things which caught my eye is (of course) the discussion initiated by Ape Man on the nature of a trade surplus. In that respect, this one from Edward is interesting I think:

'And this raises an additional issue which your model can't quite capture (I don't think) and this is why is it that export dependent societies need to grow in the first place. I mean couldn't they just sink with dignity?'

Now, I don't think Edward and I are growth fundamentalists but in a world where capitalism is the rule of the game and where after all some growth is needed demographic decliners will face some rather unique challenges going forward. This is because that 'all things equal' such as e.g. improvement in institutions, increase in productivity, etc these countries will most likely have tremendous difficulties maintaining their standard of living or, as it were, the expected increase in standard of living.

This of course brings us to the idea of the structural propensity to run an external surplus. Now, regarding Ape Man's account of a trade surplus I agree with the fundamental economic definition; no complaints there.

Regarding the definition of a trade surplus I like to see it as a distinction between an open and closed economy. In a closed economy without leakages it is not difficult to understand what would happen in the context of rapid ageing (kind of like you nomad model I guess). With one government, one firm, and one household let us say that dependency ratio climbs signifying that the amount of elderly non-working outpaces over time the amount of people working either at the government or firm. In my opinion the structural correction could potentially happen through the following mechanisms.

In terms of domestic demand we should expect this to gradually go down over time as the amount of income earning consumers go down. Add to this that saving-consumption patterns most likely will force the income earners to save more of their income to compensate for dis-saving and erosion of the capital foundation. Whether or not the government raises taxes in order to take care of the elderly or the income earners raise savings for bequest motives does not really matter since we are talking about an increased propensity to save either way which is also exacerbated by a rising life expectancy. So, in the long run the firm will not be able to sell the amount of widgets it was use to and the income earners/consumers will save more in turn.

In short, in a closed economy the society will be stuck with an inevitable structural correction as a result of ageing and potential population decline. This correction can of course occur with great differences since institutional changes and an increase in productivity will be able to fend off this effect. Now, it is important to note that such a society by no means need to be an ‘unhappy’ society but as Edward note there will inter-generational issues and as the size of the income earning group continue to shrink relative to the elderly the former will most likely see their living conditions deteriorate relative to the previous generation. In many ways it is in this potential environment that Edward and I note that it might be difficult to raise fertility or at least that this will be a very slow process.

In an open economy all this changes and in many ways I think this goes to heart of the matter AM;

For starters, I take a trade surplus as a sign that there is an appetite for a rate of return that cannot be met by the domestic economy.

Now, only in an open economy will an economy be able to fight this … as such the household becomes a retail investor sending its saving abroad in order to earn yield on its savings which in a low (domestic) growth and the firm is now able to ramp up capex (investment) again to meet capacity which was previously not present. It is precisely these two mechanisms which may serve to push an ageing economy into an external surplus. Remember also here that apart from the definition you gave of a trade surplus AM you could also look at a trade surplus as saving (financing) which run counter to other nations’ deficits. The issue from the point of view of the global economy is of course that most developed countries in world are set to age over the course of the next 20-30 years and this begs the question, will there be enough ‘deficits’ to go around? What happens if this occurs in China? Etc. I think you raised this issue in your essay too AM and more than you know I think this is at the heart of the whole debate on global macroeconomic imbalances.

Whether all this leads to the worsening of the fertility trap is of course another question and will be the subject of my next comment.