A few weeks ago I wrote about the importance of demographics in political trends. Today I’d like to show you how demographics help predict financial crises.
Here are a few examples of countries with major crises.
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- The working-age population in Japan peaked in the 1995 census.
- The 1995 Financial Crisis in Japan
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- The working-age USA population growth slows down to unprecedented levels in 2008 (see figure below)
- Financial crisis of 2007-2010. (Also, notice previous dips in 2001, 1991 and 1981, and consider the list of recessions.)
- China’s working-age population, age 15 to 64, has grown continuously. The labor pool will peak in 2015 and then decline.
There are more charts in Demography and Growth report by the Reserve Bank of Australia:
Wikipedia surveys the causes of the financial crisis, such as “liquidity shortfall in the United States banking system caused by the overvaluation of assets”. Oh my! Slightly better than the usual Democrat-Republican finger pointing, but no, no, no, no. One has to pick the right variables to explain these things. Why were the assets overvalued?
There is a simple answer: not enough people have been looking at demographic trends to understand that it’s the working-age population that buys most of the goods, services and real estate.
Back in 2007 I found a book by Henry S. Dent, the main message of which was nicely summarized by this March 2000 article in Businessweek:
The bull market is as vast and powerful as the baby boomer generation, and the two are inextricable. The 80 million or so boomers–those born between 1946 and 1964–are hitting their peak earning, spending, and investing years, and that’s what’s driving the economy’s incredible performance and the stock market’s spectacular returns. His target for the Dow is 40,000–which he believes it will hit somewhere around 2008.
After that, watch out. As an economic force, the boomers will have peaked, and there just aren’t enough Generation Xers to sustain the economic and stock market boom. Even the revolutionary changes wrought by the rapid growth of the Internet don’t change that. In Dent’s view, the economy goes into a deflationary funk for another 10 or so years, until the boomers’ children–the 83 million ”echo baby boom” generation–reach their economic prime.
Unfortunately for Dent, there was the 2001 dip before the 2008 drop.
Assuming economists finally learn the demographics they should have known for a long time, the next financial crisis will be caused by some other under-appreciated variable.
No, I think the exact opposite happened to promote the Housing Bubble, which led to the Mortgage Meltdown, which kicked off the Great Recession. The financial community focused too much on population statistics.
The Housing Bubble and Meltdown didn't really happen all over the country. For example, it didn't happen at all in North Dakota, which doesn't keep many young working people at all. (Many go off to some place warmer.)
Instead, the vast majority of dollars defaulted (approaching 7/8ths the last time I checked) were in only four state: California, Arizona, Nevada, and Florida. Each had rapidly growing populations in the years leading up to 2007-2008, especially of young working age men.
The financial industry focused too much on the quantity of population in those four "Sand States" and, because it is illegal to discuss it, not enough on the quality of the new population in those states (quality as defined by ability to earn enough to pay back a mortgage). It turned out that the new population of California, where the great majority of dollars were defaulted, couldn't earn enough to pay back gigantic California-size mortgages.
That doesn't make sense. All empirical evidence suggests consumers are forward-looking. Why aren't they using this information of trend demographic growth to form expectations of future supply estimates? Of course you could appeal to consumer myopia, but you can use that to explain anything then.
Here's a better explanation though – household balance sheets usually weaken prior to the onset of a debt-deflation type recession. Assuming people decide to have children based on their finances, then shouldn't we see a slow-down in demographic growth prior to a debt-deflation recession? In fact, this makes sense looking at your data. 1981 recession was caused by tight monetary policy by Volcker to tame inflation. Households have rational expectations so they internalized this and declined to have children during those potential difficult economic times. We know the recession of 1990-1991 was caused by tight monetary policy, so you have the same deal. The 2000 recession was simply a bubble, but it wasn't debt-deflation so you don't see the worsening of balance sheets prior to the onset so the decline came after it hit. 2006 was when household balance sheets starting worsening. All of this supports my idea that households are just rationally responding to either expectations of tight monetary policy or rationally deciding not to have children because of worsening household finances. It explains why 2000 was an outlier too.
In Japan there could be something to it, but the 1995 problem was caused by tight money. The subsequent problems could be partially attributed to demographic change since total factor productivity was shown to decline in Japan, but I'd still put deflationary BOJ policy on top.
I also maintain that most of the financial crisis was caused by the Federal Reserve allowing NGDP expectations to fall and for running contractionary monetary policy through 2008 – and still today!
"Assuming people decide to have children based on their finances" — as the opening of Mike Judge's "Idiocracy" points out, that's more true for some people than for others.
According to the Public Policy Institute of California, the total fertility rate in California (where most of the most mortgage money was lost) in 2005 was 1.4 babies per American-born Asian woman per lifetime versus 3.7 babies per foreign-born Latina. Who is more likely to earn enough money to pay back a mortgage?
The continuous growing supply of cheap labor is everything to the class that owns everything and makes a profit by employing people who have nothing. That's why the employer class is always propagandizing for population growth, both globally by having more children, and nationally by immigration. They demonize anyone who raises the alarm as people-haters, because only a people-hater wouldn't want more people.
The fact that it can't go on forever doesn't matter to this dynamic. Bubbles and bull markets always grow manically until they crash, and the first critics of the bull market are always dismissed as downers and haters. What could possibly go wrong this time?
Aging populations need to save for retirement which increases the amount of savings, lowers the interest rate, and increases asset values. Eventually populations will decline requiring negative real interest rates. Better hope we have figured out how to do that by the time it is needed. Hint: more inflation.
Ted, saying that it was "caused by tight monetary policy" is a very strong statement. Really? Also notice that my charts show working age population, so "people declining to have children" will only affect the curves 16-26 years later.
I very much share your suspicion that economists have a blind spot with respect to demographics and asset returns. Krugman used the term "demographic nonsense" regarding the public debt situation a couple weeks ago. That's just frightening.
Part of the neglect of demographics within academic economics stems from James Poterba's 2000 paper which found little historical evidence that demographic variables affect equity prices, and predicted that boomers' dis-saving in retirement would have little impact on asset prices. On the empirical side, maybe the "effective" degrees of freedom were insufficient as Poterba considered, and he did not write on Japanese data. On the model side, he only incorporated the age structure with respect to asset demand/supply, not consumption or production. If the interaction of those three factors isn't linear, one will get different results. It is very possible that I missed something, but subsequent academic papers seem to be of the same mold as Poterba, with little that is new. When you get a chance, Aleks, I would be very curious to know what you think of the Poterba paper or others.
On top of this, I would add that globalization is perhaps past its inflection point.
Actually, economists have been warning about the coming demographic crisis for at least a decade. See, e.g.,
Kotlikoff-Burns from 2004: http://www.amazon.com/Coming-Generational-Storm-A… or Diamond-Orzag from 2003:
http://www.brookings.edu/papers/2003/12saving_ors…
I'm not sure what I'm supposed to see in those plots.
I agree that the ratio of workers:retirees is relevant for economies, but the crash of 2008 seems like a completely standard financial crisis, like those discussed in the deservedly classic book "Manias, Panics, and Crashes" by Kindleberger and Aliber, originally published 1978 (now in its fifth edition, which was released in 2005). I certainly can't summarize the whole book here, but here are a few quotes from Chapter 2, "Anatomy of a Typical Crisis." (Everything that follows between the === marks is from the book).
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[Hyman Minsky] highlighted the pro-cyclical changes in the supply of credit, which increased when the economy was booming and decreased during economic slowdowns. During the expansion phase investors became more optimistic about the future and they revised upwards their estimates of the profitability of a wide range of investments and so they became more eager to borrow. At the same time, both the lenders' assessments of the risk of individual investments and their risk averseness declined and so they became more willing to make loans, including some for investments that previously had seemed risky.
…
Market prices increase, and the more rapid increase in profits attracts both more investment and more firms. Positive feedback develops as the increase in investment leads to increases in the rate of growth of national income that in turn induce additional investment so the rate of growth of national income accelerates… The authorities recognize that something exceptional is happening in the economy and while they are mindful of earlier manias, 'this time is different,' and they have extensive explanations for the difference.
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[Eventually] as the buyers become less eager and the sellers become more eager an uneasy period of 'financial distress' follows…both firms and individual investors [realize] that it is time to become more liquid — to reduce holdings of real estate and stocks and increase holdings of money. The prices of goods and securities may fall sharply. Some highly leveraged investors may go bankrupt because the decline in asset values is so sharp that the value of their assets declines below the amounts borrowed to buy [them]…The race out of real or long-term financial securities into money may turn into a stampede.
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..and so on, there's a whole book's worth, this is just the basic "model" of a typical financial crisis, and it seems to capture the crash of 2008 very well. Crises like this have happened many many times, all over the world, in countries with growing working-age populations and with shrinking ones. I'm just not seeing a demographic connection here.
Hal, from what I know they've been warning about the increasing load of the retirees – still, this work invalidates my blanket statements.
It seems to me, however, that the crisis is better explained by fluctuations in the numbers of the working age population.
Phil, the crux of the problem is *why* was there an unexpected slow-down. Once you have a slow-down, you get missed targets, losses, and an all-out a panic.
Alex, I don't think the crux of the problem is why there was an "unexpected" slowdown. When the system becomes unstable enough, anything (or even nothing in particular) can trigger the crash. You could read the book, there are lots and lots of examples; this one is exceptional for how big the bubble got before it burst, but not in other ways.
Dr. Varian, The pieces you cited seem to deal more with the stress that demographic structure is placing on government balance sheets. The aspect that I think is relatively neglected is the effect of demographics on rates of growth. If I read Aleks right, he is suggesting that recent bubbles, busts and corresponding low rates of return are a *symptom" of changing demographics. So on top of the fact that we have horribly mismanaged our balance sheet, our prospective cash flow may also be impaired. Yet this very morning I see this quote from Jeremy Siegel, "there is every reason to believe that mean reversion will continue — that is, that despite sometimes excruciating declines, the market over the long run will produce average real returns of more than 6 percent annually."
That is exactly the blind spot I suspect, and there are other reasons outside of demographics to believe that growth will not be as strong as it was in the 20th century.
For a related view, see Robert F. Martin (Fed) wrote "The Baby Boom: Predictability in House Prices and Interest Rates" back in 2005 or so.
Incidentally, if this: "The working-age USA population growth slows down to unprecedented levels in 2008 (see figure below)" is supposed to be causal of economic crisis, wake me up in 2022.
Economists are not focused on demographics as a causal force of financial crises because there is not a plausible mechanism by which demographics will cause large unexpected short run market fluctuations. Yes, demographics should affect the supply and demand of financial assets and will yield long run price adjustments, not wild short-term price fluctuations and virtually overnight breakdowns of the financial system.
Moreover, I don't find the evidence presented in the graphs terribly supportive of this hypothesis, even for such casual causal analysis. The US rate is not unprecedented. It was at or near the current level for most of the boom-boom 1990s. If this hypothesis is correct, why is working age population growth so low in 1990s? Aside from the outlying jump in the rate in 2000, the US working age population growth has not exhibited much variation since the early 1980s.
The other country graphs are hard to interpret due to the x-axis scale labeling (what would Prof. Gelman say?), but the evidence doesn't look any better. Indonesia, East Asia, Mexico, and South Korea had high growth before their crises. The demand for financial assets in these countries prior to and during their crises had little to do with indigenous demographic characteristics.
I actually think economics has pretty good understanding of crises. Phil, above, cites Minsky. Claudio Borio at the BIS has done a lot of great work on empirical implementations of the ideas in Minsky for predicting crises. But, for a number of reasons, many economists choose to ignore these ideas in favor of the "efficient market hypothesis" view and for other reasons policymakers are unwilling to incorporate these ideas into the design of financial systems and regulation.
A. Hersh, I have to find a better way of explaining that demographic turnaround (or misprediction) correlates with the onset of the crisis.
The more inflated a bubble, the faster it will deflate, as Phil pointed out. The question is why and when did it start deflating.
There are always many causes, and too often arguments descent the vicious spiral of trying to dismiss a cause or trying to pick just one cause. Our task is to help identify them, understand them, disentangle them, qualify their importance, and learn from it.
My message is – demographics is an underrated cause.