Wednesday, October 5, 2022

Review of The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival

We have known for a long time that the population of developed countries is aging. This is set in stone because of the decline in fertility rate and rise in longevity that occurred during the 20th century. The result will be an age structure diagram, or population pyramid, that is heretofore unknown in history (and which is not a pyramid).

We used to think, we now realize mistakenly, that having an inverted (aging) population pyramid would be deflationary. After all, have you ever visited a house owned by (or vacated by) an octogenarian? One of the things you notice is that they have not bought anything in years - their houses are time capsules from an earlier decade, the decade of that person's peak consumption of home furnishings. So we figured that an aging population would decrease the demand for all sorts of goods: deflationary.

Except that is not quite right. Sure, the retired and elderly probably buy fewer jet skis, couches, and cars. But they eat the same amount and they consume much more health care and living assistance. And, most importantly, they do not produce anything. From a monetarist perspective, having an aging population producing fewer goods but with money supply remaining the same (or higher) should cause inflation.

William J. Bernstein wrote an important essay almost 20 years ago called "Retirement Calculator from Hell, Part IV: A Nation of Wal-Mart Greeters," which explains this very powerfully:

At base, what we have is x number of workers supporting y number of retirees with goods and services. The retirees may be paying the workers with saved dollar bills, stock certificates, or Krugerrands, but at the end of the day, the method of savings/payment is irrelevant. As the number of retirees increases, the goods and services produced by the remaining workers become thin on the ground. In this case, it does not matter how much retirees have saved—the value of their dollar bills, stock certificates, and Krugerrands will fall to the point where the workers are finally willing to take them in exchange for those goods and services.

The world’s first government-sponsored retirement system was Bismarck’s, begun in Germany in 1883. The Iron Chancellor, wishing to co-opt the Socialists, decided on sixty-five as the retirement age, and we have been stuck with it ever since. In an age without adequate nutrition, antibiotics, high blood pressure medicine, and rudimentary occupational safety, only a few percent made it past the finish line, and those that did survived only a few years. Even when Franklin Roosevelt signed the Social Security Act in 1935, relatively few lived to qualify—in that year, there were forty workers for every beneficiary.

How things have changed. Today, the median life expectancy for men is seventy-five years; it’s eighty for women. Currently, there are three workers for every retiree; by 2050, there will be only 1.5 workers supporting each retiree.

Imagine, if you will, a desert island on which there are only five inhabitants—four workers and one older retired person. Each of the four workers does several odd jobs: growing various foodstuffs, building shelter, providing rudimentary medical care, and the like. The medium of exchange is coconuts. Every month, each of the four workers gives a few of his coconuts to the retiree.

One day, one of the remaining four workers turns sixty-five and decides that he, too, wishes to retire. If he does so, instead of each worker supporting 0.25 retirees, each would be supporting 0.67 retirees. Not only that, but the total GDP of the island would fall by 25%; so would per capita GDP. What do you suppose the response of the remaining three workers will be to an apparently healthy-looking colleague who demands that they support his idleness?

Let us further assume that the candidate-retiree has planned for his nonproductive years by accumulating a disproportionate number of the coconuts. In doing so, he has done nothing to increase the productivity of the island. Now that he must spend the coconuts, the island will find an increased number of them chasing 25% less goods and services. The result is a predictable bear market in coconuts and dramatically more expensive goods and services.

Worse yet, to the extent that he has planned ahead and saved, he sows social discord, for even if he himself has accumulated enough coconuts to counteract the effects of higher prices, he has raised prices for everyone else in the process.

This example was not arbitrarily chosen. The 4:1 and 3:2 ratio of workers to retirees is about what was the case in 1990 and what will be the case in 2050, respectively.

In an era when a small number of people lived past sixty-five, society could easily support them for the very few years they survived beyond that point. Now that citizens are routinely living two decades longer, it is simply not mathematically possible, let alone politically feasible, to expect each worker to support 0.67 retirees, no matter how many coconuts, dollar bills, stock certificates, or Krugerrands they save up in the meantime. It is also not reasonable to expect productive younger individuals to support large numbers of healthy older non-workers.

As Arnott and Casscells succinctly conclude, what we have is not a savings crisis, but rather a demographic crisis. We will not be rescued by increased voluntary or enforced savings. The idea of investing Social Security funds in stocks, so fondly embraced by right-wing think tanks, is a prescription for capital-market instability. (The most salient feature of the American Enterprise and Heritage Institutes is just how little thinking actually goes on inside them.)

The solution, then, is for folks to retire later. We’ve already started down that road by raising the retirement age for future retirees to sixty-seven. Unfortunately, we have a ways to go. In order to keep the current worker-to-retiree ratio at 3:1, Arnott and Casscells estimate that the retirement age will gradually have to be raised to seventy-three. Of course, the government need take no action; politically, it will prove far simpler to let poor asset-class returns and low savings force older Americans to postpone their retirements. In the past few years, millions rudely awakened to the fact that they weren’t going to retire at forty. Over the next few decades, most of the remainder will discover they won’t be doing so at sixty-five, either.

Another person who believes that aging populations (and as a corollary, current developed country demographics) are inflationary is "inflation guy" Michael Ashton:

It seems to me that people who argue that aging populations are disinflationary don’t really have a useful model in mind. If they do, then it revolves only around [the idea that a higher retiree/non-retiree ratio probably implies lower spending], and [thus] that spending will diminish over time; if you believe that inflation is related to growth then this sounds like stagnation and deflation. [...]

The decrease in potential growth rates due to the graying of the population is real and clearly inflationary on its face, all else equal. Go look at our MV=PQ calculator and see what happens when you lower the annual real growth assumption, for any other set of assumptions.

Economists Charles Goodhart and Manon Pradhan have come to the same conclusion, that an aging population is inherently inflationary, and they wrote a book before the pandemic to make the case: The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival. A summary of their key points:

  • "The rise of China, globalisation, and the reincorporation of Eastern Europe in to the world trading system, together with the demographic forces, the arrival of the baby boomers into the labour force and the improvement in the dependency ratio, together with greater women's employment, produced the largest ever, massive positive labour supply shock. The effective labour supply force for the world's advanced economy trading system more than doubled over these 27 years, from 1991 to 2018."
  • "We are in a debt trap. Debt ratios are so high that increases in interest rates, especially at a time in low growth, may drive exposed borrowers into an unsustainable state. As a result, the monetary authorities cannot raise interest rates, either sharply or quickly, without running into the danger of provoking another recession, which itself would make everything worse. But that will leave interest rates, and the accompanying flood of liquidity, sufficiently expansionary (accommodating, in Central Bank speak) that debt ratios are likely to increase even further."
  • "The basic problem is that ageing is going to require increasing amounts of labour to be redirected towards elderly care at exactly the time that the labour force starts shrinking. [...the] portion of the labour force looking after the elderly will produce service for immediate use rather than durable consumption. These services [...] are unlikely to be replaced by automation [and] cannot be offshored the way the lowest value-added activities in manufacturing were offshored."
  • "Ageing is inflationary empirically, too. Juselius and Takats (2016) uncover an empirical relationship - 'a puzzling link between low-frequency inflation and population-age structure: the young and old (dependents) are inflationary whereas the working age population is disinflationary'."
  • "If the growth rate of workers in the economy outweighs that of dependents (as was the case during the demographic sweet spot), the world will go through a period of disinflation as it has for the last few decades. Over the next few decades, [however] the rate of growth of dependents will outstrip that of workers."
  • "[The] Great Reversal of demography and globalisation will lead to more inflation. When this takes hold, though it may be a few years from now, and expectations adjust, then nominal interest rates will rise. Of that, we are confident. But the more difficult and interesting question is whether nominal interest rates will rise by more than inflation, i.e. whether real interest rates will rise, or whether the reverse will happen and real interest rates will fall."
  • "[G]rowing inequality within countries has been mainly caused by the unprecedented surge in labour availability, caused by globalisation and demography, leading to a dramatic decline in labour's bargaining strength. If so, Piketty is history. But we could, of course, be wrong."
  • "But what will then happen as the lock-down gets lifted and recovery ensues, following a period of massive fiscal and monetary expansion? The answer, as in the aftermaths of many wars, will be a surge in inflation, quite likely more than 5%, or even on the order of 10% in 2021..."
  • "What will the response of the authorities then be? First, and foremost, they will claim that this is a temporary, and once-for-all blip. Second, the monetary authorities will state that this is a , quite desirable, counterbalance to the years of prior undershooting of [inflation] targets, entirely consistent with average inflation, or price-level targeting. Third, the disruption will have been so great that it will take time to bring unemployment back down towards 2019 levels and large swathes of industry, (airlines, cruise ships, hotels, etc.), may still be in difficulties. Does it make any sense, having propped up industry in such a widespread manner in 2020, to let much of that same industry go to the wall in 2021 as a result to rising interest rates and fiscal retrenchment? In any case, the borrowing lobby (government, industry, those with mortgages) is much more politically powerful than the savings lobby." 
  • "The balance of bargaining power is now swinging back to workers, away from employers; current, more socialist political trends are reinforcing that. Following the recovery, whenever that happens, wage trends will change. The likelihood is that wage demands will then match, or perhaps even exceed, current inflation, despite the inevitable pleas for moderation in the context of a 'temporary blip' in inflation. The coronavirus pandemic, and the supply shock that it has induced, will mark the dividing line between the deflationary forces of the last 30/40 years, and the resurgent inflation of the next two decades."
  • "The losers will be savers, pension funds, insurance companies, and those whose main financial assets take the form of cash."
  • "Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate. The excessive debt, amongst non-financial corporates and government will get inflated away. The negative real interest rates that may well be necessary to equilibrate the system, as real growth slows in the face of a reversal of globalisation and falling working populations, will happen. Even if central banks feel uncomfortable with such higher inflation, they will be aware that the continuing high levels of debt make our economies still very fragile. And if they try to raise interest rates in such a context, they will face political ire to a point that might threaten their 'independence'. Only when indebtedness has been restored to viable levels can an assault on inflation be mounted.""

In the wake of the pandemic, we are all noticing inflation, higher interest rates, and most oddly, a strange shortage of labor. You may try to eat at a restaurant and find that while there are empty tables, you have to wait because there are no waiters available. Are we already noticing the falling worker-retiree ratio?

If the authors are right that the falling worker-to-retiree ratio will lead to higher low-skilled wages and then to falling inequality, it may be bearish for luxury goods companies that have been benefiting from the rising inequality. Think of Ferarri. Investors think that it is a "perma-compounder" that will keep on doing well forever, but this implicitly assumes that wealth inequality is a one-way trade? 

It trades for 40 times earnings. If leverage shifts from capital to labor, the oligarchs' profits will decline and it would presumably be bearish for Ferarri. In that case, the current valuation would be a classic case of double counting: trading at a high multiple on peak earnings.

On the other hand, there are companies that seem to connote "luxury," but which are not only not exclusive, but in fact derive their customers from the underclass. Just this year, we have been noticing lines out the door at Louis Vuitton and Gucci stores. We can tell by looking at the customers in line that they are most certainly labor, not capital. Could LVMH actually benefit from power shifting to wagies - is it perhaps even already benefiting from this shift, since we have only noticed the packed stores post-pandemic?

The authors devote quite a bit of effort to the counter-argument to their thesis that Japan did not experience inflation when its population began seriously aging. Mike Ashton ("Inflation Guy") also felt the need to address this in his 2018 post:

I think that most people who think the demographic situation of developed nations is disinflationary are really just extrapolating from the single data point of Japan. Japan had an aging population; Japan had deflation; ergo, an aging population causes deflation. But as I’ve argued previously, the main cause of deflation in Japan was overly tight monetary policy.

He thinks it is because of monetary policy; Goodhart and Pradhan think it is because the labor glut was worldwide. (Note that Inflation Guy wrote a review highly recommending Great Demographic Reversal.) So it is interesting that Japanese inflation is starting to rise at the same time that it is everywhere else in the world. That is what you would expect to see if the great disinflation had been caused by the worldwide glut of labor which is now reversing.

It is also interesting that Goodhart and Pradhan address how this will affect interest rates: "monetary authorities cannot raise interest rates, either sharply or quickly, without running into the danger of provoking another recession, which itself would make everything worse." If you recall our Rethinking Inflation post, we quoted Harley Bassman (@convexitymaven

Why do rates have to go up? The Fed can keep them down. They kept them down post-World War II. Maybe that is what the plan is. They will just buy like Japan. They’ll just buy the bonds and balance sheet them and keep rates at one, one and a half. Even if we have 4% inflation, you’ll have a massive negative rate. That’s really the question here is that once you break the linkage of inflation to rates, a whole lot of things are possible. Now, the answer I think is this. Let’s say they have the three or four-handle inflation. Let’s say the Fed or the government or someone, I mean the government could do it by demanding that banks buy treasuries. They could force banks to do that because they’re regulated entities. So there’s a whole lot of ways for the government to keep rates at the current levels, if they want to. So what happens then, the other side of the balloon gets squishy, which means currency devaluation possibly. We don’t become the reserve currency of the world anymore, which seems unlikely, but whatever. There’s a whole other host of things that could play out where you keep a massive negative interest, real interest rate, which is unclear. But the usual game, if we weren’t the world’s reserve currency, we’d have a devaluation.

Banks own tons of treasuries, and their balance sheets have been devastated by the increase in the ten year bond yield, something that is being chronicled over at Oddball Stocks. Higher interest rates also mean that the interest on the $31 trillion federal debt grows, which is a positive feedback loop since the debt is not being serviced. And high interest rates choke the economy, which is unpleasant and also lowers tax revenue - worsening the debt spiral - and causes banks' loans to default. 

So it has seemed clear to us that printing money to buy bonds (yield curve control, capping bond yields) is the path of least resistance, "kick the can" approach that the regime will choose:

The Fed talks a lot about tightening but hasn't done much tightening.

We like ConvexityMaven's theory that the Fed is going to do yield curve control. Instead of letting the bond market crash and taking everything else with it, print money and buy bonds - keep the yields capped. But as the Maven says, in this scenario, "the other side of the balloon gets squishy" - meaning inflation.

If you look around the world, you will notice tons of countries with fiat currencies are running high inflation rates. Meanwhile, deflationary collapses are rare. Can you imagine the central banks of Brazil, Argentina, or Ghana tightening enough to cause a deflationary collapse? It has never happened, because the path of least resistance is inflation.

Betting on inflation is the cynical bet. But we have to be cynical enough to realize that the central bank doesn't want us hoarding real assets and is going to try to trick us with jawboning talk. People will believe the talk and there will be violent selloffs. This is why we like "first class" inflation protected assets and not leveraged junk.

If this theory of yield curve control is correct, holders of CD's or investment grade bonds may not lose too much more in nominal terms, since yields will be capped at some level. But they will lose a tremendous amount in real terms due to the inflation. And their loss will be the gain of equity investors in leveraged enterprises with pricing power, like Magellan.

But again, the Fed is not going to make it easy. With their tough talk (lots and lots of talk) they have convinced many people that they are "serious about winning this inflation fight." Even good ol' ConvexityMaven believes it. 

The one person we follow who really vocally (and enthusiastically) makes the case that the Fed is bluffing is Kuppy. He calls the moment that their bluff is revealed "The Pause," as in the announcement that they will be pausing the tightening program:

the Fed has followed through much as I expected they would. Look back to my prior posts that warned that they’d turn against the markets for a bit (Post 1, Post 2, Post 3). They’ve done a whole lot of talking, but precious little in terms of concrete actions. They got people convinced that they’d go full-Volcker and take rates into the teens, but we all know that they won’t. A pause is inevitable.

Of course, they will do the bare minimum to try and regain some credibility, but it is all for show. These guys don’t actually care about inflation—they care about enriching their buddies in Private Equity while pretending to care about “inclusive economic policy” and other woke-word-salad nonsense. Of course, they’ll pause on rates at the first sign of real economic pain. The history of the Federal Reserve for the past few decades is that they overstimulate, then try to reign things in; until they break something, leading them to overstimulate again. Once on the hamster wheel, their only choice is to spin it faster. Meanwhile, the fiscal side is already preparing for another trillion in stimulus to supposedly fight inflation—they clearly have even less stomach for a pullback.

Therefore, I find it baffling that so many investors got so bearish back in June and July. Look, we all have PTSD from 2008. It was a miserable experience that I never want to repeat. That said, this isn’t 2008. Anyone who thinks that it is, is asking to get their portfolio debased by “Project Zimbabwe.” The lesson that the Fed learned from blowing up the financial system back then, is that once it starts to unravel, it’s harder to put it all back together again—just look at how extreme their response in March of 2020 was. Even after it was obvious that they had flooded the market with too much liquidity and inflation was spiraling out of control, the Fed wasn’t taking any chances—they kept plowing ahead with QE until the first quarter of 2022.

It is clear that they prefer inflation to another lost decade of patching up the financial system like in the 2010’s. Oddly, investors think that the Fed will take rates to a level where it detonates things

Kuppy also agrees that energy is the best way to play inflation and the pause. It is simply incredible that first the electric vehicle delusion and now a credulous belief in the Fed's hawkish talk have made hydrocarbons available for investors to buy so cheaply.

We give The Great Demographic Reversal a 3/5. While we agree with the thesis that an aging population is inflationary, we can think of at least three other major reasons to expect that we are entering a new secular cycle of inflation. Stay tuned for our upcoming post about this.


viennacapitalist said...

Your „saving – really, hoarding - of coconuts“ of example was illustrated by Wicksell in his famous lectures (he used gold coins instead of coconuts) in order to illustrate of what happens when saving occurs in the medium of exchange: at first the hoarding is deflationary, i.e. prices fall. Due to the price fall society can consume more and does not save “in aggregate”. Later, when the hoarder consumes his savings, prices increase and we have a forced reduction in consumption, in order to enable consumption of the hoarder.

Now, the situation is different, says Wicksell, if the savings get lent out by an intermediary, i.e. a fractionally reserved bank: in this case there is no price fall, and productive capacity is increased (this was written at a time when banks did not make consumer loans). In this case, when the saver consumes his savings and the investments have been productive, there is no increase in prices, as the dissaving is accompanied by increased production. This is the ideal case.

In reality, due to monetary and fiscal distortions, we have malinvestments (as evidenced by the fact that there have never been price decreases) and it might will be that in the future we have price increases that are larger than in the hoarding example, i.e. than what would occur in a primitive society.

The unique supply shock of the last 35 years, coupled with theoretically unsound (“a growing price level”) CB mandates has helped enable these distortions.

CP said...

There are, of course, bond fortunes: Citadel started out focused on convertible bonds, Bridgewater has done very well with fixed income, and Appaloosa had many of its early wins in distressed credit. But run down the Forbes 400 list's finance section and those investors are outnumbered by the equities-focused managers. And by the private equity fund managers, whose asset allocation is technically long equities and short bonds. And many of the funds that started out bond-focused have since diversified into equities (of course, some of the equity people diversify into bonds, too).

Two asset classes, similar risk-adjusted returns over multiple generations, and it's easier to get rich owning one and shorting the other than focusing entirely on the wrong asset class. It's an interesting puzzle!