Tag Archives: demographics

The Alice in Wonderland world of low interest rates

When interest rates go close to zero, it is possible that central bankers might just slip down a rabbit hole and discover that what used to be up might now be down.

There is a growing chorus of people arguing against central banks using low (even negative) interest rates to stimulate the economy.  One of the reasons that people point to is that when interest rates are low, cutting them further induces savers to save more.  The logic is that there are two offsetting effects a) a price effect — the lower return on savings makes people more inclined to consume today rather than wait for tomorrow; and b) an income effect where the fall in people’s income from lower interest rates induces them to have to save more today to satisfy their future spending needs.  Economists nearly always assume that the first effect (known as the substitution effect) outweighs the second effect (the income effect). This traditional assumption implies that the supply of savings in an economy is positively correlated with the interest rate.

But when this standard assumption does not hold, and the income effect more than completely offsets the substitution effect. In this case the supply of savings in an economy becomes negatively correlated with the interest rate.  It seems most likely that this could happen when interest rates start to get close to or below zero.  Figure 1 illustrates two savings supply curves, one for each of our two cases.

Figure 1

Fig 1

Whether the traditional assumption about the income effect holds or not when interest rates start to get close to zero is important for policy makers. To see why think about how monetary policy normally works.  Suppose that investment demand is shown as in the figure, and that the equilibrium real rate of interest is r0 (i.e. the rate of interest that equates savings supply with investment demand at A).

Now suppose that the economy looks like slipping into recession. The central bank sees signs of weakening demand for goods and labour. So the central bank intervenes and cuts interest rates below r0.  When it does this, there is an excess demand for investment over savings, which stimulates spending and boosts the demand for goods and labour.  Recession avoided. Good job central bank.

But now suppose that things are different and that investment demand is much lower. Indeed most economists believe that the equilibrium rate of interest has fallen in the last 20 years because of a shortage of good investment opportunities (i.e. a fall in investment demand).  This would shift the investment demand curve in Figure 1 to the left leaving Figure 1 to look like Figure 2 below.

Fig 2

In Figure 2 we see that in the traditional case, the new equilibrium interest rate is lower corresponding to the new equilibrium at point B. If the economy now started showing signs of recession, the policy prescription would be no different  than before — cut rates.

But if the non-traditional assumption held, then things get more complicated. Investment  demand and savings  supply now intersect twice at C1 and C2 and there are now two equilibrium interest rates associated with the two equilibria C1 and C2. But only the one associated with the higher interest rate (C1) is a stable equilibrium.  By this  we mean an equilibrium at which if the economy started to show signs of slipping into  a recession, the central bank could cut interest rates and thereby  create an excess of investment demand over savings supply and help to stimulate the economy to avoid recession. If the equilibrium was at C2 instead and the economy showed signs of recession. A cut in the interest rate in this case would cause savings to rise by more than investment and the recession would get worse, rather than being alleviated. This is the case that some economists are worried about.

The possibility that the savings supply curve might actually be backward bending (i.e. exhibit the non-traditional shape) means that there could  be a constraint on central banks abilities to prevent a recession and prices from falling.  Even if the economy is at an equilibrium like C1, the possibility of the negatively sloped savings supply curve limits the ability of central banks to make deep cuts to the policy rate for fear of driving the rate too low below C2 and creating a deflationary spiral.

Before ending this post, there are two last points to consider. First, it is possible that the slow fall in investment demand and rightward shift in savings supply that the world has witnessed in the last 20 years may continue (especially in countries where populations are starting to age dramatically, like Japan and Europe and even China).  In which case, it might be possible that there is no intersection between investment demand and savings supply (at least not at full employment, which we have been implicitly assuming in this post).  Second, it might be that at really low (say negative) interest rates, investment demand becomes infinitely elastic.  In which case, eventually the central bank could still achieve its goals of maintaining inflation and avoiding if it was willing to go negative enough.   Regardless, the simple analysis here is meant to highlight just one thing, that the economics of monetary policy could soon be much more complicated than one thought.


Japan’s “seniors’ moment”

Torrens read somewhere that Japan’s working age population is set to decline by something like 17% over the next 17 years (though data  from OECD says it’s more like 14%). This can be seen by the shift from the green distribution to the red.


Regardless of whether its 17% or 14%, it got him thinking about what the implications would be for the world’s third largest economy from such a significant decline in its workforce. The prospect of an aging Japan is starting to worry investors.  And, to borrow from Paul McCartney, TH reckons Mrs Suzuki might now be wondering whether financial markets will still love her when she turns 64? (Mrs Suzuki was the hypothetical representative Japanese investor that Canadian economist Kenneth Courtis used to use to animate discussions like this).

The demographic shift gives us two main issues to think about.  On the one hand, there is the effect on the labour force and the underlying structure of the economy.  On the other, there is the effect on savings.  In practice, the two issues are different sides of the same coin, but it helps to think about them independently.

The structural shift in Japan’s economy

First, it probably means that the labour force will contract, even if people like stay at home mums (or dads) are encouraged to enter the work force.  Second, given that Japan is a relatively high cost manufacturing location, it probably won’t be able to attract investment in quite the same way that China, Korea or Vietnam can. Put these two pieces together and it becomes fairly obvious that Japan’s GDP growth might well turn negative simply because the supply of productive resources (the amount of capital and labour) will be shrinking.  And unlike China, which can import productivity improvements from advanced economies, Japan which is on the technology frontier and may struggle to boost productivity growth in the future (though enhancing technology is something the Japanese clearly excel at).

Second, unless there are some other adjustments, most of the decline in productive capacity is likely to be in Japan’s labour intensive services sector rather than the capital intensive manufacturing sectors.  That is, the declining labour supply will likely result in a fall in the supply of services relative to manufacturing.

A savings shift

During the last 40 to 50 years, the Japanese have been notoriously thrifty.  It has consistently sold more onto world markets than it bought and saved the difference.  As a result, it is now the world’s largest net creditor. Its net international investment position was around 60% of its GDP in 2011. As its population ages, it will start running down those savings and it will start to spend a larger share of its income.

The increase in spending will probably go on both goods and services, but to the extent that the spending is likely to be age related, the mix is more likely to be on services than at present.

Bippity Boppity Boo

So put all this together and what do you get?  If this analysis makes sense to you, then you will likely conclude that over the next 17 years, demographic change in Japan will result in an increased demand for services at a time when the supply of services starts to decline.  As a result there will be an excess demand for services relative to goods, and one should expect the price of Japanese services to start rising (or alternatively the price of goods will start falling).

There are two ways this adjustment in relative prices can happen: either through inflation, or an appreciation of the exchange rate.   Until the recent dramatic change in policy regimes in Japan, it was the exchange rate that was appreciating.  Going forward, given the new monetary stimulus, inflation could play more of a role than previously expected (especially services prices).   Arguably, the sharp yen appreciation during the financial crisis and the shift of Japan’s trade deficit into surplus is an indication that these forces are already at work.

So why the worry about Japan?

By itself the forthcoming adjustment should not be a major source of concern so long as markets are able to adjust and clear the excess supplies and demands, all should be OK.  So why is everyone so worried about Japan these days?

The answer has to do mostly with the savings shift.  You see, despite Japan’s sizable holdings of foreign assets, it is widely believed that Japanese investors have a strong bias for Japanese assets. A phenomenon called home bias. Such a bias tends to mean that the price of these assets is driven up and correspondingly the yield on these assets is driven down.  In this respect, home bias has been a good thing for the Japanese government, which has issued a lot of debt (in net terms, it’s just under 140% of GDP).

Essentially, the Japanese government sold bonds to its high-saving, middle-aged population with the promise that future generations would repay them (you could imagine that one of them was Mrs Suzuki).  Now, instead of raising taxes (or cutting spending) to repay its debts, the government (with a budget deficit of around 9% of GDP) is borrowing heavily and rolling-over its existing debts.

But with Japanese saving less, the Japanese government will have to start relying more heavily on foreign investors to hold its bonds, and these investors are not likely to be as kind as Mrs Suzuki was to the Japanese government.  Increasingly, the marginal buyer of Japanese bonds won’t have a strong bias for Japanese assets; they will treat them just as they would any other asset and so the yield on Japanese government bonds is likely to start to rise.

Age related mis-calculations

Additionally, when fundamentals change (as they are in Japan), there is the chance that people (including policy makers) don’t recognise the changes that are underway and make decisions that are inconsistent with the new reality. In this case, the natural slowdown that the Japanese economy is experiencing might be misinterpreted as a lack of demand. Policy makers may be tempted to engage in too much stimulus for two long, creating excessive burdens of government debt and credit growth.

From Torrens Hume’s perspective, an aging population, increasing financing costs and excessive credit growth sound like a combination of factors to take pause over.

Shabash India? India in the global economy

At a cricket match in India you will here cries of “shabash!”, as the batsmen clad in pure white (or brilliant green, sky bue orange orange) wallops the ball out of the ground for six runs. It means “Good on ya’ mate” in Australian (or well done, bravo).

In an earlier post, it was argued that the recent news of an economic growth slowdown in China was consistent with the aging of China’s population and the end of its demographic dividend. And TH wondered whether we could soon be saying shabash India as it becomes the next major driver of global growth?.

There are lots of reasons to be optimistic. Let’s start with the same UN demographic data used in the earlier post.  The first chart shows the end of China’s demographic dividend is due to start sometime soon.  India, on the other hand, the share of the working-aged in India’s total population is still growing and is not forecast to start its reversal until somewhere around 2040.

Consequently, the share of world’s working age population that lives in India is set to continue its rise while China’s will continue its downward trend.  Once you account for participation rates, the change is even more dramatic.  Right now about one quarter of the world’s workers are in China, that falls to below 20% by around 2030, at the same time India the share of the world’s employed that reside in India will rise from around 17% to around 21%.


In 6 to 7 years, the contribution from China to global employment growth (currently around 0.2% per year) is set to become negative, while India will account for about half a percent to global employment growth of 1.5%. India looks set to continue to account for around one third of global employment growth for the next 3 to 4 decades.

But, just as there are reasons for optimism, there are many reasons for caution. India faces many challenges.  The quality of India’s workforce is one of those challenges. Take youth literacy for example. Youth literacy is important, because it tells you about the productivity of the next generation of workers, and compared to many of its peers, India is struggling.  At just over 80%, the youth literacy rate in India in 2007 was lower than it was in Sri Lanka, Brazil, China, and Indonesia way back in 1970. So to the extent that global employment growth is being driven by Indian workers rather Chinese workers, the contribution to global GDP growth will likely be somewhat smaller. This point is reinforced by data from Penn World Tables on output per worker. GDP (adjusted for cost of living) per worker is about $11,300 in China and $7,500 in India. So unless something dramatic happens in the next 5 years, the effect on global growth will be modest at best when the globe starts relying on Indian workers to replace retiring Chinese workers in 2018.

There are many other factors at play too.  India’s labour market laws introduce notorious rigidities that impede growth and its governance of property rights makes it difficult for innovators to leverage capital into productivity growth.  So, from where Torrens sits, its too so to say Shabash India.

The real question is how quickly can India close the literacy gap, improve labour market regulations, and improve the institutions that could help transform India’s vast wealth into innovation and productivity enhancing growth. But, those are issues for another post.

Shabaash India is also the name of an Indian reality TV show: