Wednesday, November 30, 2011

Aging and retirement trends to create surprise shocks for global economies

Support ratio will deteriorate significantly over the next two decades
As developed countries struggle to deal with funding the retirement benefits and medical care for the aging Boomers, they will also need to prepare for other impacts associated with the changing demographics.  Most significantly, countries must face the dramatic decline in the support ratio associated with an aging population. It is projected that the support ratio in developed countries will decline from an average of 3.5 working adults per retiree today to below 2:1 by 2050.  By comparison, in 1970, the support ratio was above 5:1.  Not only will countries need to care and provide for the largest pool of retired workers in history, they will also be supporting these retirees with untenably few number of workers. A key consequence of reduced support ratio will be high domestic inflation as the large number of consumers bid up prices for the services and productions from the few laborers.

Aging population and trade deficit
People consume goods and services which are produced by workers. A sharp decline in the American and other developed country workforce means that developed economy households must either reduce consumption drastically or increase reliance on imports from emerging countries.  Thus, the trade deficit between developed countries and the emerging countries must continue to widen aggressively, or the per capita consumption, and therefore, the standard of living for developed countries must decline precipitously.

However, the only way for most developed countries to maintain (and increase) their trade deficit against the emerging countries is to borrow heavily from the emerging countries. If the PIIGS are any indication of what is to come, the balance sheet, and ultimately the credit rating, of the developed economies simply would not allow further aggressive borrowing or further trade deficit.  This foretells a significant deterioration in the standard of living for many developed countries.

Boomers and their retirement planning
Demographic shifts are generally considered to be non-risk events, in that they can be fully anticipated ahead of time. Saving, consumption, and investment decisions would allow individuals to largely manage the (adverse) effects of (unfavorable) demographic shifts. Boomers should have anticipated the untenable support ratios in their retirement. They were supposed to save aggressively during their working years (delaying pre-retirement consumption) and then convert their large and plentiful retirement assets into retirement consumption, particularly paying up for imported goods.  Boomers should also have anticipated a significant rise in the cost of domestic services, which cannot be effectively imported from foreign labor markets.

Instead, what we observe today is inadequate retirement savings. First of all, it is long understood that the pay-as-you-go (vs. fully pre-funded) social security scheme cannot work effectively as a credible mechanism for inter-generational risk-sharing in the face of declining support ratios. There are insufficient numbers of young people paying into the system to support the social security payments for those who have retired. Whether the U.S. social security is a Ponzi scheme or not is largely semantic.  The reality is that the social security payments are not pre-funded and the U.S. government must either change the terms of the payments (a soft default on the obligations) or miraculously find significantly more tax revenue in the near future.  The backstop plan, pension schemes, or forced retirement savings, are meant to protect workers from the risk of social security insolvency.  Unfortunately, low contributions, high costs, and poor governance/institutional design have generally led to poor funding and adequacy ratios as well as poor coverage for pension plans. 

No matter what the existing laws governing retirement benefits (which of course were passed under the Boomers' watch) might say, the unfortunate truth is that there is insufficient funds.  The problem is far beyond taking from the savers and giving it to the non-savers; in the aggregate, we didn't save enough--this cannot be dealt with by simple wealth sectional transfers from one part of the population to another.  It is an unavoidable outcome that the Boomers retire later and with lower retirement benefits than they were expecting. 

Asian Demographics
Unfortunately, the major Asian economies are also aging rapidly.  Japan is already quite old.  Taiwan, Korea and other Asian Dragons are aging rapidly due to low birth rate.  This means these net exporters and supplier of global consumption goods will start to export less as they also face domestic decline in labor force.

In fact, these Asian countries will start to reverse their trade surplus and begin to import more aggressively to fill their domestic production gap. (Please see the blog posts "Does Asia export too much?" and "Understanding cheap currency policy).  The mechanism will likely be a combination of strong currency policy and decumulation of savings for the Asian countries.  The latter of which would equate to demanding debt repayment, in the form of consumption goods, from the Western countries.  The combination of weakening U.S. and European currencies, which makes Asian goods less affordable to Western retirees, and the debt repayment to Asian countries through increased exports, means that Boomers will face an even more severe price inflation than what is predicted by the massive reduction in support ratio.

Debt and demographics interact (in a bad way)!
The problem is further compounded by an inability to further borrow against the future. This failure is not due to a lack of political will and mechanism to exploit our children, but by the inconvenient reality that the future has already been fully monetized. Rating agencies and international lenders are starting to be uncomfortable with the debt capacity of the developed countries.

The European debt crisis truly came at the utmost inconvenient time—just before the Boomer retirement wave. To understand the negative interaction between demographics and debt, one merely needs to understand why banks would not lend large sums of money to an old retiring senior with hefty existing debt.

The heavy debt burden for the Western world will have negative impact beyond preventing additional borrowing to smooth retirement shortfalls.  The debt also needs to be repaid.  By the very same argument above, the Asian countries, which have been saving and running a trade surplus against the Western world, will start to decumulate their retirement savings and demand debt repayment, in the form of import goods, to deal with their own demographics challenges in their retirement.  This means the few Western working adults would need to ship a significant portion of their outputs overseas at a time when there is already insufficient production.

Conclusion:
What was a predictable inevitability—the reality of an aging population—that could have been managed, will likely become a shock that surprises economies and markets in a most unfriendly way. Instead of saving during their peak earning years, Boomers spent.  Instead of building wealth for retirement, Boomers accumulated debt.  Now the chickens are coming home to roost; instead of a gradual and smooth change in rates and prices corresponding with the gradual shift in demographics, the likely outcome is a volatile and violent transition from the old equilibrium to the new.  In that new equilibrium, not only will Boomers retire later with significant benefit abrogation, they will simultaneously face tremendous price inflation, which erode what little purchasing power they may have left.

by jason c hsu

**Special thanks to Sue Heilbronner (Sharky Sue) for suggesting the title for this article!

27 comments:

Kim in TO said...

well put! I hope you are "releasing" your fears for the future as much as I have been...and will now need to again given your well stated thesis! Kim in TO

Larry Kornman said...

Thanks Jason I am really enjoying the blogs. Can the US mitigate its issues by increasing immigration?

Diana Chapman said...

Thanks for clearly articulating the patterns you see in a way I can easily digest. I'm also grateful for the heads up.

CrimsonDye said...

I think immigration can be one of the most powerful solutions. Generally, most people who want to come to the U.S. are drawn to one or more of the followings: democracy, freedom of speech, meritocracy, working opportunity, education, political freedom, religious tolerance---these are fantastic qualities that we want to foster in our population! What can be more fantastic than attracting people like that to our country to contribute!

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