Over the past several years, widespread debate over the state of the US economy has continued, with a host of different explanations being used to justify the stubbornly sluggish growth rate. Many economists have agreed in blaming the Fed: some blame it for doing too little, while others blame it for doing too much.
As for the Fed itself, it has chosen an entirely different way of looking at the slow growth problem: denying that the problem exists in the first place. The official narrative so far has been to put blame on some unforeseeable external pressures, like the EU debt crisis or the Chinese economic slowdown. However, all of the Central Bank’s measures are working according to plan and the economy is still on track to a full recovery.
This line of defense might seem tentative at best, and rather unsustainable considering the mounting facts and figures against it. Only last month, however, a timely “way out” of this argument appears to have arisen in the form of a new study. According to a paper published by the Fed’s Board of Governors, economists Etienne Gagnon, Benjamin Johannsen and David Lopez-Salido argue that the reason for the anaemic growth lies in demographics, or, to be more specific, the slowing of population growth. They contend that the country’s demographic changes accounted for “essentially all” of the declines in both economic growth and interest rates in recent years.
An exculpatory explanation
According to the core argument of the paper, slow growth and low interest rates were an inevitable outcome of demographic changes in the US population. Akin to a force of nature, such economic “phenomena” are beyond Central Bankers’ control and there was nothing they could have done to prevent them. In fact, the paper claims that the economic decline of the last 35 years is entirely and directly attributable to birth rates; fiscal and monetary policy, technology, geopolitical factors, or other changes in productivity had nothing to do with it.
To support this theory, the three economists devised a model that shows how demographic changes such as births, deaths, aging, migration, labor markets and other trends have impacted the U.S. economy since 1900. They focus on the baby boomers, who as the chart below shows, represents the largest American generation with 76 million people born between 1946 and 1964. The paper examines the impact that this demographic had over the last decades, as it moved through the American age distribution curve, as well as the corresponding and particular effect on the labor market.
The US labor market reached a peak in the 1960s and 1970s, as the boomers reached working age and joined the nation’s labor force en masse. Ultimately, this generation became the most significant growth factor for the US economy at the time, boosting productivity as well as interest rates.
Then, the women’s rights movement, along with the rise in both availability and use of birth control, contributed to an even greater workforce with a much wider participation of women. As a result, the number of workers relative to the total US population reached a historic high.
However, the women’s rights movement also contributed to reduced fertility rates, dropping to less than two children per woman by 1980, from an average of more than three in the early 1960s. As the boomers aged and retired, they left behind fewer people to replace them in the American workforce.
The next generation could not fully replenish the labor supply, and the gap their parents left has stifled the country’s economic output. As explained in the paper: “Our model predicts that demographic factors caused real GDP growth to rise about a percentage point from 1960 to 1980. From 1980 to 2015, the transition toward lower growth in the labor supply erased that increase: Initially, the decline was modest but picked up around the year 2000.”
As explained in the paper, the boomers not only affected economic growth, but interest rates as well. When they began expanding in the workforce, more capital flowed into the economy in the form of new roads, factories and equipment, which in turn helped boost productivity. The retirement of the baby boomers meant that this capital is overabundant for the now-smaller workforce. This crushed the return investors received for investing in capital, thereby discouraging any new investments, and by extension, lowering real interest rates.
As shown in the following chart, the real interest rate in the United States rose through the 1960s and 1970s, reaching its peak around 1980s, but has gradually declined along with aging boomers ever since.
According to World Bank figures, population growth, which has averaged 0.8% since 2007, is projected to remain slow. Thus, based on the underlying argument of this paper, we can expect economic growth to also remain slow.
An admission, long past due?
The most significant revelation in this report is two-fold. First, the economists make it clear that this inevitable economic outcome was “largely predictable”. However, the paper’s conclusion closes with a surprising admission: “The model suggests that low investment, low interest rates and low output growth are here to stay, suggesting that the US economy has entered a new normal.”
This is a dramatic departure from the Fed’s narrative so far. It sharply contradicts officials’ statements insisting that the recovery is in process, thanks to the polices and measures that were taken, and that we will soon see growth return to the historical norm.
The paper also invites more questions than it answers: Does the demographic explanation “absolve” the Fed from any and all wrongdoing in the making of today’s economic troubles? If slow growth was indeed inevitable and predictable, why did policymakers pursue such drastic expansionary policies? Why were interest rates kept at near zero levels for so long, mushrooming the public debt to GDP from almost 82% in 2009 to over 105% today? And finally, if the US birth rates are entirely to blame for slow growth, how will that affect future policy decisions?
The paper ends by noting that “the persistence of a low equilibrium real interest rate means that the scope to use conventional monetary policy to stimulate the economy during typical cyclical downturns will be more limited than it has been”. Can this be interpreted as leaving the door open to more radical policy options? Might it be a green light to follow Mario Draghi’s lead and take interest rates into negative territory, a move that has been up to now considered taboo by the Fed?
The timing of this publication could also be quite telling. It comes at a time when investors have their eyes set on Janet Yellen, closely looking for clues and hints about when and if the promised rate hike will take place. Mrs. Yellen might have firmly rejected a negative rates scenario, while postponing the hike decision from meeting to meeting. And yet, it is not inconceivable that we could see her position “evolve”, as she appears to be faced with an uphill battle ahead.
It’s not just the Fed economists and their demographic theory that paint a dismal picture for the future. The Congressional Budget Office is projecting a 2.4% growth for 2017 and 2.2% in 2018, before slowing to an average of 1.9% between 2019 and 2026. Meanwhile, the Federal Open Market Committee is even less optimistic, targeting 2% in 2017 and 2018, and 1.8% thereafter.
If multiple stimulus programs through QE and zero rates did not suffice to resuscitate the US economy, the obvious question becomes what will the Fed try next? And if the paper’s conclusions hold true, what policy direction could possibly compensate for the demographic problem? Per the trends that we’ve seen in recent years, it seems that Central Banks everywhere are typically drawn towards more, not less, aggressive policies to achieve their targets.
Thus, it would be reasonable to assume that, rather than concede defeat, policymakers will most likely “double down” with more money injections into the economy or further interest rates tampering.
This article originally appeared on MountainVision.com