The Evolving Economy

The economic impact of the impending demographic decline

Key points

  • The rise in longevity is a welcome development and one that we can only hope continues
  • Many emerging economies are likely to see a rise in longevity, which should provide a ‘demographic dividend’
  • These trends will account for additional divergence between advanced and emerging economies over the coming years but over the longer-term will act as a headwind at a net global level

Longevity a key contributor to the demographic decline

Life expectancy has continued to rise markedly in recent decades. The World Health Organisation (WHO) suggests the global average rate is now 72 years (2016), up 5.5 years from 2000 (and 30 years since the mid-19th century). Even as gains in longevity have paused in some countries, such as the US and UK, the broader global rise is expected to continue over the coming century.

Increased longevity has contributed to a massive rise in the global population, a rise that in turn has spurred global growth. Moreover, alongside the long-term decline in global fertility rates[1] , it has led to a significant ageing of the global population. For the last few decades this has reduced both children and retirees as a proportion of the workforce (the dependency ratio) and provided a meaningful boost to economic development.

As these trends persist and continue into the 21st century, many emerging economies will continue to benefit. However, ageing is rising more dramatically in some economies than others. In Europe, the number of over 65s now constitutes a larger proportion of the population than the under 15s[2] . Ageing is particularly advanced in certain developed economies e.g. Japan, Germany and Italy, and is rising quickly in China.

These older societies face a reversal of the falling dependency ratios as the growth of retirees outstrips that of the workforce. In some cases, workforces themselves, are plateauing or even falling. This effect has been exacerbated in Western economies by the ‘baby boomer’ generation[1]  - the bulge in the population following post-war peace – reaching retirement. The ‘demographic dividend’ that propelled growth in the latter half of the 20th century is shifting into a ‘demographic decline’ with some meaningful macroeconomic consequences.

Economic growth to suffer as longevity affects dependency ratios

As this demographic decline takes effect, economic growth should slow. Both of the key components of long-term potential growth, labour supply and productivity growth, look set to be affected.

Workforces[4] are expected to decelerate modestly over the OECD as a whole (to 0.8% per annum this decade from 0.9%), while a number of economies, including Australia, Canada, Spain and Belgium will see deceleration in excess of 0.5 percentage points (ppt) in the current decade. The following decades are projected to show workforces stagnate - rising on aggregate by 0.1% in the 2030s, 0.0% in the 2040s and -0.1% in the 2050s. Within that aggregate, Japan, Germany, Italy and Spain are projected to record declines. 

Longevity will mitigate some of this decline. Increases in life expectancy can lead individuals to choose (or states to force) workers to work longer. The OECD records the effective retirement age has risen by two years to 65 in the two decades to 2016, while participation rates amongst the over 65s have risen sharply, particularly since the financial crisis. However, the net effect on the workforce is dominated by cumulative declining fertility rates.

Productivity growth is also likely to be affected by ageing societies. As with many aspects of productivity growth, theory and evidence are mixed on the outlook. Some factors suggest an older workforce could be less productive. These include:

  • Historically, older workers have been less quick to adopt and adapt to new technology and have been more risk-averse.
  • Historic profiling suggests a ‘productive peak’ around the late 30s with productivity declining thereafter. (5) This creates productivity ‘composition effect’ as the workforces age[5].
  • Worker mobility appears to decline with age, reducing efficient job-matching
  • In some industries, declining physical health will also be a factor

Yet much of this evidence is based on historic trends that might evolve. The average age of Nobel prize winners or great technological inventors increased by eight years over the last century[6]. Moreover, many jobs are now ‘white collar’ professions that offer the prospect of continued accrual of experience which could boost productivity. This is particularly the case if labour shortages drive wages higher, potentially increasing the returns to educational gains and boosting life-long learning.  

The outlook for investment is also important. Capital deepening could emerge as the labour force slows and eventually falls (rising capital per worker). This could boost labour productivity. But capital deepening should reduce the incentive to invest on aggregate. With research and development (R&D) spending historically a proportion of total investment, R&D could fall, reducing the outlook for productivity growth.      

Empirical evidence is difficult to interpret. There is clear evidence of declining productivity growth in Germany, Japan, the US and UK over the past 10 years, where workforces have aged. However, it is difficult to determine the cause of slowing productivity growth from the after-effects of the financial crisis, a trough in technological innovation and these demographic effects.

In the US, the National Bureau of Economic Research (NBER) estimated growth-ageing elasticities based on state-level data (including six states of ageing populations and three in outright decline)[7]. Its estimates suggested that for a 10% rise in 60 plus year olds as a proportion of total population, labour productivity fell by 3.7ppt. Intriguingly, this suggested that productivity growth fell across the age distribution in affected states - suggesting a complementarity of younger/older workers. The study also concluded that this would reduce per capita GDP growth by 5.5ppt.     


And lower interest rates…

Demographic effects have also contributed to an overall reduction in neutral rates, from a peak in the 1980s to the present day. This reduction is consistent with the decline in market and policy rates over the same period.

Neutral rates are likely to have been affected by both the decline in trend growth, and productivity, in recent years. As we argue in our assessment of US neutral rates[8], potential growth rates are not the sole driver of neutral rates. However, the decline we anticipate, which reflects demographic effects, should continue over the longer term despite the expected reversal of some post-crisis effects on deleveraging and the demand for safe-assets.

Demographic effects should also weigh on interest rates through other mechanisms. Capital deepening would lower the marginal productivity of capital, directly affecting its price - interest rates. Relatedly, an expected slowing in total investment growth should also reduce the demand for capital, also lowering its price. 

There are also behavioural changes that should emerge from an ageing society. Saving should rise as workers, particularly baby boomers, prepare for retirement. Offsetting this, life cycle hypothesis suggests that as people reach retirement they begin to ‘dissave’ i.e. reduce their savings and drive the price for available funds higher. We argue in the following article[9], that evidence of life cycle hypothesis dissaving is scant and so far the combined effect is for higher saving but this may reverse over time.

A number of empirical studies also confirm the theoretic case that population ageing is likely to result in lower interest rates.[10],[11]

Public finance stresses require policy mitigation

Demographic developments are also likely to have a number of indirect effects on the health of public finances in advanced economies. Government tax revenues are likely to reflect falling economic and productivity growth, particularly as labour and consumption taxes are likely to fall disproportionately in an ageing society.

Longevity will also play a key role in directly increasing government spending costs. These should reflect increased healthcare and social security spending as the population ages. Healthcare and social care spending increase disproportionately with age. Pension costs will also rise. US pension provision begins at the age of 62 and the government’s commitment increases for every additional year of life. This is equally true in European economies where state pensions are often unfunded and subject to significant longevity risks. The International Monetary Fund (IMF) estimates that for any unanticipated three-year increase in longevity, the costs of ageing would rise by 50% - an additional cost of 50% of 2010 GDP in advanced economies.[12]  

Some of this additional cost of ageing societies will be mitigated by the expected drop in interest rates, which in turn will reduce government financing costs. Yet these gains are likely to be relatively small. Governments will need to adjust policy to address fiscal deterioration. The sooner these changes are made, the smaller the overall adjustment that should be required. But most are not addressed for now. Long-term projections of US public finances show that beyond recent fiscal stimulus, the US debt outlook is set to deteriorate sharply, rising to approach 100% of GDP by the end of the next decade and 152% of GDP by 2048.[13]   

There are broadly four options to mitigate the rising costs, which include, increasing funding for the services, reducing the provision of the services, increasing the retirement age or boosting immigration (of younger workers). However, each option faces conflicting social tensions.

Increased contributions (public or private) could fund the spending gap. Yet this would exacerbate the short-term economic impact, adding to medium-term budgetary pressures. Moreover, younger generations would face increased spending for both their future provision and that of previous generations.

Cutting entitlements  spending also risks a macroeconomic impact but faces a broader inequity - poorer households are disproportionately affected by reduced entitlement spending but do not experience the same increased longevity benefits of richer households.

Increased retirement age would likely prove the least distortive means of addressing increased longevity. However, it again suffers from the inequity that poorer households do not share the increased lifespan outlook.

Immigration can also help alleviate these costs, with immigrants usually being younger workers. However, developed economies are currently facing increased social tensions against rising immigration. 

Governments have become unwilling, and in some instances unable, to make the necessary policy changes to address the expected impact of ageing in advanced economies. Yet the need to address these issues only looks set to grow over the coming decades. 

Diverging emerging and developed economies to converge over the long term

The rise in longevity is a welcome development and one that we can only hope continues, despite signs of fading in some advanced economies. However, the impact that rising longevity will have on individual economies will be highly dependent on the stage of those economies for now. Most emerging economies are likely to see a rise in longevity, along with declining fertility rates, which should provide the same ‘demographic dividend’ that boosted many advanced economies and underpinned those making the transition from developing to developed.

However, for many advanced economies (and some emerging), this trend is already giving rise to meaningful macroeconomic shifts. The net global impact of rising longevity is likely to be increasingly apparent over the coming decades. While the impact of financial markets, with a greater focus on developed market trends, is already apparent as a contributor to lower interest rates. In the longer-term, even those emerging markets will eventually face the same steady-state outcome that developed markets are currently approaching.


Longevity series

Chapter 1 - Q&A: Dani Saurymper & Emeritus Professor Thomas Kirkwood

Chapter 2 - The economic impact of the impending demographic decline

Chapter 3 - Ageing populations are not a death knell for asset prices

Chapter 4 -  Longevity on the one hand, fertility declines on the other

Chapter 5 - China: Coping with a Silver Society

Chapter 6 - The impact of longevity on the insurance business

[1] Global fertility rates have more than halved from 5 births per woman in 1960 to 2.4 in 2016 (World Bank).

[2] Over 65s total 19% of the population, under 15s 16%. Eurostat, 2017.

[3] In the US the baby-boomer generation was that born immediately after WWII between 1946-64, in Europe birth rates picked up more slowly but had risen materially by the early 1950s.

[4] OECD potential employment of total economy

[5] Studies testing psychometric ability over different age groups do see a deterioration in some cognitive abilities, including speed, but concludes that age accounts for a small share of variance once experience and education are controlled. Cross-sectional employer-employee matched data estimate productivity peaks at 40, but contradictory findings have also published from US insurance industries and German car production firms. 

[6] Jones, B.F. “Age and great invention”, 2010.

[7] Maestas, N., Mullen, K.J., Powell, D. “The effect of population aging on economic growth, the labour force and productivity”, NBER, July 2016..

[8] Page, D. “Following r*”, AXA IM Research, March 2018

[9] Add in Maxime and Varuns reference

[10] Nerlich, C. and Schroth, J., “The economic impact of population ageing and pension reforms”, ECB, Feb 2018.

[11] Gagnon, E, Johannsen, B.K. and Lopez-Salido, D. “Understanding the New Normal: The Role of Demographics”

[12] “The Financial Impact of Longevity Risk”, IMF, April 2012.

[13] Congressional Budget Office, June 2018.


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