Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Sean Creehan.
And I’m Paul Tierno. We’re analysts in the Country Analysis Unit, and our job is to monitor financial and economic developments in Asia. Today we continue our series Rethinking Asia, as we consider noteworthy and unusual trends in Asian finance and economics.
Today we talk to Manoj Pradhan, of Talking Heads Macro in London. He’s an expert in the relationship between demographics and capital markets, looking at how aging and labor force changes impact everything from global interest rates and wages, and perhaps most provocatively, inequality. Prior to his current role, he worked as a macroeconomist at Morgan Stanley.
Yeah, I think this is a fascinating topic with a lot of variation, even inter-regionally, within Asia. Japan is probably the most obvious case study for what happens when developed economies age. China is poised to grow old before it gets rich. But at the same time, we see other countries, like India and Indonesia, that have large, growing economies, young workforces, that are generally benefiting from what economists call, “a demographic dividend.”
In that sense, the region really isn’t monolithic and the impacts of demographics will be quite varied over the coming decade.
This is close to home for you Sean, right? You’ve done some research on the topic. What did you find?
Yeah, I just looked at this quickly from a slightly different perspective in a recent blog, specifically at how the growing cohort of middle-aged workers and investors in Asia may represent a sweet spot for demographics and investment. And it was really good to get Manoj’s perspective here on the broader economy.
Okay, great. Let’s hear it.
Thanks for joining us today, Manoj. You’ve written a lot about the effect of demographic trends on the global economy. What were some of the dominant trends, and their economic consequences, of the past few decades? And also, how are those trends expected to change?
Sure. First, thanks for having me, I’m really very happy to be here. Let’s start with your question. It’s been a profound change over the last 30 or 35 years and we think it’s going to be an equally profound one going forward. This is not a period for the soft hearted.
Over the last 30 or 35 years, what we saw, in fact, starting from the ’80s and into the ’90s, what we think is a one-time gigantic supply shock of labor.
It started with the advanced economies around the ’80s and the dependency ratios over there—which simply means the number of workers related to the number of dependents, both old and young—started increasing.
And then in the ’90s we got something that is historic—and we’ve come to see it as historic—the integration of China and eastern Europe into the labor supply of the economy, which was an absolutely huge shock. On our simple calculation it’s about a 120 percent increase in the effective labor force as these two gigantic parts of the global economy slowly began to get integrated. And that led to the huge number of changes that had an impact on inflation, it had an impact clearly on wage growth, and because China’s financial markets were segregated from the countries that set interest rates for the rest of the world—which are the advanced economies—it also led to a significant difference in who invested and who saved. And because investment declined in the advanced economies it also led to a decline in interest rates.
So we’re at a point right now where a lot of these trends are changing, and in fact, if you look at it from an economic perspective, the labor force is aging precisely in the economies that have become the manufacturing powerhouses of the world. Where economic activity has rapidly increased over the last 30 or 35 years the supply of labor now is moving down sharply. It’s all across the advanced economies. It’s happening in eastern Europe, and north Asia is going to age fairly rapidly.
And that’s going to lead to a reversal of a lot of the changes that we have taken for granted. Financial markets are telling us that inflation, interest rates are going to remain low for a very long time. There’s been a cyclical uplift in people’s expectations that in the long-term most people expect demographics to mean very benign conditions and very few risks. I think both demographics and the implications they’ll have on economic and financial markets are going to be completely different from what we think is likely to happen.
And so you don’t think markets are actually anticipating that properly right now? You don’t see that as priced in?
No, it’s not quite priced in. I think clearly there’s been a lot of expectations that have been set over this deep cyclical downturn that we’ve had, in addition to the structural trends of demographics, and that led people for a while to talk about inflation dying out. But right now, if you look at most of the narratives that are playing out, they’re talking about the revival of the Phillips curve, not a structural inflection in the inflation.
So whatever pick-up you’re seeing in inflation expectation will be attributed to a cyclical strength story that is coming from, possibly a synchronized pick-up in growth, possibly an over-heating of some late cycle economies, but I don’t think we’re pricing in that demographics are going to turn against us from a tailwind to a headwind, and that is going to lead to inflation and higher interest rates.
The narrative throughout financial markets is that whenever demographics do take a hold of the global economy you’ll get a very Japan-like deflationary or disinflationary scenario, which I think is what’s depressing expectations about interest rates as well.
So that’s an interesting point, right? Because these trends, they mark a huge shift in both inflation and interest rates. So how do you envision the economy, and really the markets too, working their way to this new equilibrium, and how do you envision central banks managing that transition?
Let’s take your second question first. I mean, we gave a lot of credit to central banks, starting with the Reserve Bank of New Zealand. Inflation targeting was introduced and there’s been significant progress—the Volcker recession all of these things we’ve attributed to the credibility of central banks, their transparency, but perhaps we’ve given them too much credit. They entered the inflationary fight when a disinflationary trend was already underway through demographics.
We think that their ability to fight inflation over the next few decades is going to be significantly limited compared to what people believe right now. They will fight in the initial stages. The sacrifice ratios I think will start turning against them.
Manoj, before we go on could you just elaborate maybe for our listeners, you used the term “sacrifice ratio”—could you explain what you mean by that?
Yes, absolutely. I should’ve been clearer. It’s the amount of output that has to be given up in order to reduce inflation by a certain amount. And typically speaking the literature behind the “sacrifice ratio” would tell you that, at very high inflation rates, bringing inflation down fairly rapidly has very, very few impacts on growth, because bringing inflation down say from 30 or 25 percent—as has been recently the case in Argentina—tends to clarify a lot, it tends to give them a lot more confidence in the real rate of return will be, or what your real wage will be in year or two.
And so you don’t really have to sacrifice growth that much in order to bring down inflation, but when you are talking about relatively low levels of inflation—it’s in the five or the six percent range and you want it bring it down to two or three percent—then sometimes, like Paul Volcker had to do, you have to induce a recession. And that means that you have to sacrifice growth in order to actually get rid of some levels of inflation.
I think the term will take on a very different meaning when you’re talking about demographics, because these are not cyclical episodes. I think what will happen is, as inflation starts moving up because of demographics and central banks try and control it, then after they throw increasing amounts of fire power behind keeping inflation under control, that’s going to create—at least in the near-term—a drag on their economy, until they realize that inflation is actually something that is not a phenomenon they can control very well. And once that realization sets in, I think people will be able to reset what inflation means for their economies, what it means for real wages, what it means for output, and that will lead to a certain easing, in fact, of the way the economy grows.
In a sense, as they try and stick to inflation targeting when inflation starts getting away from central bank control, they are going to go through a very difficult period where both markets and policymakers will have to adjust their expectations over what central banks can control and what is driving inflation. The two might be very, very different things.
And the way the market will adjust is, they will have an episode or two that really convinces them that central banks are not necessarily in charge. That’s typically how market expectations have been formed or reformed. Take the post-recession period for example, and the post-recession period after the great financial crisis. There were plenty of times when markets through the Federal Reserve would raise interest rates, and it took quite a few disappointments for something like the secular stagnation thesis to actually grab a hold, and those expectations have now been set in a very similar fashion over the next half a decade or a decade. I think we’re going to start seeing episodes slowly but steadily over which inflation creeps higher, and that creeping inflation is what eventually convinces people that there’s a new paradigm in place that we really should be paying more attention to. That’s simply not the old model over the last 30 or 35 years, which was conditional on a trend that has now reversed itself.
Here in the Country Analysis Unit of the San Francisco Fed, we typically focus on Asia. I’m wondering if we could unpack the demographics of Asia specifically. I mean you’ve alluded a bit to, of course, the supply shock from China and now its aging population … Reading today, about continued issues in terms of restrictions on the number of children in China and the long-term effect on the demographics of course. And Japan is a quite famous case of an aging population.
I’m wondering though, the region has a fairly diverse mix of demographic profiles still, so in India we see actually a huge and young population, a large and growing workforce. Similar in Indonesia. How do those countries fit into this mix? I guess maybe, on net, we’re seeing an aging globally, but will these other sort of demographic trends in Asia have any countervailing force? How do you think about the region in general in terms of the demographic profiles?
It’s a very, very good question, and none of these stories are going to be uniform or singular. Even within those economies there are significant details that we have to account for when it comes to demographics. But you’re absolutely right. I think it’s very important to understand that it’s not the entire world that is going to go through this aging process. In fact, in addition to India and Indonesia, Africa’s got a rapidly growing population of young people who will come into the workforce.
But focusing on Asia, I think there are two divides that we can think of. One is the aging process, and if you look at north Asia—you look at Malaysia, Thailand and certainly Korea and Taiwan and China, and then on top of that, Japan—you’ve got a north Asian contingent that does look like it’s going to have a very rapidly aging population.
The southern part of Asia does not have such significant stories, particularly Indonesia and India. I think they’ve got what we would think of as a demographic dividend that still has a way to play out, and in fact some of those are happening now. If you look at some of the details coming out of Korea, with a lot of the capital that they’ve got accumulated, or the savings that they’ve got accumulated, rather than investing right there and then, you’re seeing a demand for investing back some of that savings into places like Indonesia and India, and I can tell you first hand that the Japanese interest in investing in Indian companies is significant. From being here on the ground I know first hand that many people are trying to get funding for businesses that they are launching around here, and the interest from Japanese corporates and Japanese financial asset holders is significant.
So there is already a trend that’s trying to say, “Look, we know there’s an aging problem coming into our economies. Some of the savings that we’ve got have to be deployed in order to generate better capital. If we don’t have that capital we’re going to try and move some of it.” So some of the realization of these diverse trends is also happening. But there is a couple of other competing things that we have to look at fairly closely. Firstly there’s a technological divide which intensifies that story. For example, if you look at north Asia. The technological tiering in north Asia is somewhat like this: Japan, Korea and Taiwan are very much at the top of the technological ladder, then you’ve got Malaysia, possibly Thailand, a step below is China. But these countries, all in north Asia, make up what you would call the technological heavyweights in Asia. Then you’ve got a pretty big gap to come down to places like India, Indonesia and the Philippines, which are a few rungs lower, and they’ve got a long way to go if they have to think about catching up with the guys who are on top. Then you’ve got a much lower level as well when it comes to places like Bangladesh and Vietnam, who have a lot more work to do when it comes to technological adoption.
So in some senses, this plays out to the benefit of south Asia, because when you want to think about what you would do with an aging population, the first thing that comes to your mind as well, some of the changes in technology and advances in technology are fantastic, but when you look at north Asia, that problem is a little harder to solve, because a lot of these countries have already moved up in terms of automation, in terms of using technology. China does have a long way to go—there’s a lot of promise there. And if you look at southern Asia, if you look at places Indonesia or India, their capital stock and the level of technology in the current capital stock is so low that they’re the ones who stand to benefit the most from adopting more advanced technologies and increasing the stock of capital, yet they are the ones who have the greatest supply of labor coming online.
So there’s a bit of a mismatch that goes beyond I think just where the demographic trends are if you look on the capital side, and it does make the job harder for Asia to adjust to what’s coming in terms of aging.
Will some of these countries experiencing a demographic dividend, will they ultimately become the new global manufacturing centers, and will that help to offset the aging of workers elsewhere?
I think yes, to some extent, that is going to happen. The question is how much of it will happen. I mean, if I reinterpret your question another way—I’m not sure if this is what you were asking—but one of the questions that we get on a regular basis is a lot of supply of labor that’s coming online in Africa and India and Indonesia, could that not be enough to offset what is happening in the advanced economies and in north Asia and in eastern Europe, by becoming the new factory floors, exactly as you’re saying? The capital’s already there, the advanced management technology’s already there, some of the physical capital could be supplied. These countries could then end up producing a lot more, and you need not feel the demographic pressure as much in the rest of the world.
It’s a very interesting idea. I think there is some real evidence of some of that already happening as we just talked about, but I think it’s the magnitude where you will fall short. What you need in order to actually offset effectively the headwinds to labor in the rest of the world is an ability to transform capital into output in a way that just does not exist in a lot of these economies. So in India for example, you go back to the days of the License Raj, even though some of that is behind us, what we think needs to happen is you need to have a complete overhaul of the ability and the ease of doing business in India. The administrative capital that needs to be deployed over here … There is some scope of that happening under the Modi administration which is why, like everyone else, structurally we’ve been excited about India. But is it enough to offset what’s going on in the rest of the world? Is Indonesia going to be able to take on some of that and offset it? Can Africa help with all of this? We really doubt it.
What can happen, and I think what will happen, is that the rate of return on investment in economies with very benign labor dynamics will also work out very nicely for those economies. They will catch up with the rest of the world faster, but I think their ability to offset what’s going on in there will be very limited.
And I just want to end this answer with a very simple word of caution. We look at the Arab Spring, and that gives us a few ideas about what happens. The Arab Spring was effectively one part of the story where a lot of young people did not feel that they had the opportunities in order to deploy themselves or in order to earn a really good living, and that’s one of the challenges. Places like India and Indonesia will solve them when there are millions and millions of voters coming online, and I think incoming administrations or administration wannabes who are going into elections anywhere around these places will have to prove to people time and again that they’ve got a plan that they can execute to give employment—and gainful employment—to a lot of the young people that are going round. They’ve got scope of doing that, but it’s the administrative capital—or the lack thereof—that stands in their way.
This is kind of connected, I think, to one of the more provocative points in your earlier research. These aging pressures, by driving wage increases, might reduce inequality within countries. I’m just wondering if you could elaborate more on this. I think there’s other interesting effects of the scarcer labor supply and wage increases. I mean in China you might even argue that it’s helping to rebalance the economy more towards consumption. I mean there’s always been discussion of over-investment in China and the need for more of a services-based economy based on consumption demand. I’m just wondering if you could elaborate on these sort of beneficial side effects of wage increases from your perspective?
This is, I think, one of the really important topics that we will pay a lot more attention to—all of us, not just in our own particular research. So the deal that we made as such, if you look at what happened to asset prices, interest rates, inflation since the 1980s, going back to our very first question, the demographic dividends that we kept receiving for 30 or 35 years drove interest rates across the borrowing horizon lower consistently for decade after decade. And that raised both the ability and the willingness of people to borrow and lend, because they felt, “look, I can always pay this back. Asset prices are going up, the value of the asset that I’m buying to leverage are growing. That allowed everything to rise, and while that was going on, even if it meant slow but steady increases in inequality—and I’ll get to that why that happened in a second—we were willing to deal with it. That was kind of the price we paid for this very benign period of one part of our economic balance sheet if you will. By paying the price on the social side that we were happy to ignore for a while.
Now what has changed is, once that economic dividend has actually stopped looking as benign, we are no longer happy as a population, or as a group of people, to accept the price that we were willing to pay in the past. So inequality has obviously shot through the roof over this tumultuous decade, but I think if that rise was slower and we still could manage a decade or two more where wealth could increase for everyone. I think the question of inequality would not be as serious as it is now. But we can’t do that.
So what led to the rise in inequality was the fact that you had declining interest rates. The asset prices went up, the house prices went up, and at the same time, the huge supply of labor that we saw reduced wages. Effectively, from the ’90s wages were set in China—that’s the equilibrium real wage. And as that equilibrium real wage was set, the real earnings in the advanced economies then gradually were brought under pressure when it came to growth. So you had asset prices rising on the one hand, you had the share of labor and the economy falling on the other hand, and inequality obviously was the result of that. Now if we are right, and inflation is going to rise, and possibly even the real interest rates—or at least they will stabilize at levels higher than most people think—then those trends could be reversed. So you will pay an economic price right now which we are not ready for, but the social benefits of that will yet to come.
When it comes to China I think there are some difficult stories that are playing out as well, but there will be I think some economic benefits. For example I think what will happen in China, for very Chinese reasons, is a very Japan-esque evolution of the manufacturing and the services side of the economy. Once fixed asset investment collapses it’s very difficult to raise productivity growth on a very solid basis. And so your real income growth will also fall over a period of time. That will move you towards consumption in some senses because manufacturing and investment cannot remain strong for such a durable period of time, but also what happens is because your population is growing at a much slower speed per capita incomes are supported much better. You start paying much more attention to social safety nets. The ability to protect your savings as you open up the economy’s financial systems starts increasing.
So I think not just whether it’s on paper that it becomes a more consumption driven society, but actually in people’s way of living. I think the rebalancing of the economy is a very, very important phenomenon. It will happen in a way that’s less benign than a lot of people think, which means that you will get investments staying very low for a period of time, but consumption will be better supported, which means it will mathematically become a larger share of GDP. But, even then, the benefits that accrue to a slowing population as a country the size of China continues to grow—especially because they are not yet rich, there are many pockets of inefficiency that can still be exploited—I think those will create benefits.
And finally if I add one more thing. As we were talking about the north-south divide in Asia, I think it’s clear, to me at least, that the southern economies are going to be able to catch up over a period of time at a much faster pace than before, with northern Asia and, in fact, the rest of the world. And that’s a gigantic portion of our population that we are slowly but steadily going to lift from an extremely low level of incomes and a very high level of poverty, and that can only be good news for social justice and for economics in the rest of the world.
How will these countries where labor costs for less skilled workers are already rising—say for example South Korea—how will they adjust their economies to navigate political and national identity issues such as the types of work a country has traditionally engaged in, and also, another topic that you’ve spoken about, inequality?
It’s a very, very tough problem to solve. I think one of the things we’ll have to deal with—I think there’s not just that—but they’ll have to start dealing with thinking about some of those workers whose wages are very high doing things that cannot be shipped overseas.
So one of the problems with the South Korean manufacturing sector is that they tend to produce everything. They tend to try and capture a lot of the value added—in fact, all of the value added—in the things that they produce, and with the wage pressures that you very rightly spoke about, I think what’s going to happen is you’ll have to see a reshaping of the industry that will force people to move—as they did in Japan—into more services-oriented sectors. So what you saw in Japan was, after the collapse of the manufacturing sector in the ’90s, investment actually did not go above positive levels for nearly a decade, and over that period of time you saw a lot of people moving in the services sector with the effect that, now, if you go into Japan, they’re very proud of their huge services culture. The attention that is paid to customers, or the attention that is paid to individuals in these services sector is absolutely gigantic, because the services sector is one of the places where you can protect wages, where if you’ve got a social norm that pushes employment to be a significant national priority, then you can’t just get rid of people and force them to lower the wage.
I think, in Korea and all over the world, a few things are going to happen. Number one: I think a lot more of the people who are currently working in manufacturing or services jobs that are not related to aging will have to start moving into jobs relating to aging. That hasn’t yet happened because yes, while they’re aging, they’re not yet feeling the full brunt of the aging of the population.
The second thing they’ll have to think about is, there will have to be some give and take in terms of reallocation of the resources that go from the extremely rich and are given to the young and people who cannot really command that kind of a wage. So one of the things that we think is going to happen is the aging process will push governments to tax incomes or to tax wealth in the future, and some of that reallocation is going to happen.
And the third thing that is going to happen is, well simply the labor force is going to get smaller. So some of the job losses that are in place—or that are coming through—will not necessarily, over a period of time, be unwelcome. I think in the near-term, because these things don’t happen at the rate of aging, they will create disruption, and the disruption that is created in that point of time will lead to social pressures, it will lead to political pressures. But over longer periods of time, at a more glacial pace, I think you’ll start seeing that some of the jobs that had to be taken away from there—some of the low-end jobs that had to be shipped abroad—that was the right thing to do..
I’m wondering, on the topic of switching to jobs that are, kind of, in trend with the aging population. If you look at Japan, with its shrinking labor force, there is some concern that there may not be enough people to even fill some of these jobs, and of course immigration can be a sensitive issue in some Asian countries, it certainly is in Japan. So to the extent that a country is unable to bring in labor to fill that gap- to what extent is it going to be automation? You talked a little bit already about the shortage of labor driving wage increases and the declining costs of capital—not just investment capital, but fixed capital like technology. To what extent is that going to be a response in your view?
I think part of the reason Japan hasn’t been forced to do a lot more is because if you look at the global trend of interest rates and the ability to raise debt, I think Japan’s had a very, very good run in that sense, which may not be great for them in the future, but they’ve been able to throw a fair amount of government debt at the problem, at providing facilities without really creating the kind of pressure that we’re talking about. I think in the future that’s going to be harder for almost everyone, with the result that we will be able to force people to try and think about automation to the greatest account.
Now there are two extremes. On the one hand, some of the work that we have done talks about having too few workers, and at the other end there is a growing body which talks about running out of jobs because machines will do all the work. Well, the truth clearly has to fall somewhere in between. And here are a few points that I think we should think about. First is financial markets and popular opinion does tend to overshoot. I think for every job that we fear automation will take away from us with some degree of uncertainty, there is a much greater certainty in assuming that an aging population will force us to create jobs that robots will find increasingly hard to do.
The problems of an aging population are very different from the problems of a young population. The diseases that we have to deal with are neurological in most cases—so Alzheimer’s and issues like that—are not things that are relatively short to deal with. People live for a very long period of time with these kind of issues. Each case is completely different, and that means the medical services, the physical attention that you have to give to this, can be a very idiosyncratic story, which we all know is a low part of automation and robotics to deal with. I think automation and robotics of very, very easy artificial intelligence has to grow a lot more. They’re much easier when it comes to repetitive tasks. When it comes to non-repetitive or idiosyncratic stories they become harder to do. The second thing to think about is … The level of automation that you want to achieve is easier to see in some sectors.
What Japan has done marvelously, if you look at their robotics hotel and things like that, they’ve managed to go into services to a much greater extent, and I think that’s good. In fact, in our view, we need all the automation that we can possibly generate. But I think generating enough automation—or any kind of technological advances—in order to make people redundant, is a very far cry. These things have been talked about for decades and decades and decades—right from the time automation became an issue. There have been many periods in which people have said, “look, people are no longer going to be relevant in the next 10 years or 20 years,” and it simply hasn’t panned out.
And a few examples of that can be found anywhere, but I’ll walk you through two or three things before I talk very quickly about Japan. One of the things that people panic about is driverless trucks or driverless cars. Driverless trucks will be able to work much longer hours, and that means there’s no more need for truck drivers, and that it will reduce jobs. But I think if they’re working for longer hours, then it stands to reason that both ends of the distribution chain will also benefit somewhat. You think about car production. Car production can be automated, but the differences in wages in car production is that it’s difficult to see every part of the world getting automated rapidly. If you think about what it costs for an autoworker in the US, it’s about $25. What it costs in Mexico is $2.
So again, the drive of automation in many places, and given Asia has such a different structure of wages, the cost of labor is so different in north and south Asia, it’s very difficult to see. And finally coming back to Japan, I think Japan will need to automate, they definitely will, but what you will also see is that immigration pressures in Japan will become so significant that they will have to relent somewhat on that. It’s not something that we can see right now. If you think of the Greek crisis, it took a real crisis in order to raise the retirement age a couple of years. That was just a couple of years. So we are talking about a period in which you need significant pressure, you need significant automation, and if that automation is not able to solve all the problems of an aging population as we don’t think it will do, then some relenting from politicians and from society will be seen on immigration issues as well. I think all parts of that machine will have to work to solve the demographic problem.
Manoj, just picking up there, it also sounds like automation might be able to help fill some of the other sectors of the economy and therefore create a little bit more labor to fill in some of these jobs that aren’t as automatable because, as you say, they’re not repetitive tasks, it’s much more idiosyncratic and requires a human.
We’re not seeing the full breadth of what can happen with these unintended consequences. For example, one of the things that’s happening through better searches is that the retail industry is getting decimated. And that simply means that sectors with better returns now will, over period of time, start to occupy places that were once occupied by retail where the rate of return was high. So over a period of time a lot of this disruptive technology is going to lead to better returns to capital.
But what’s really interesting, I think—especially in Asia—is that, in some cases, there is no stock of capital to disrupt. So places like India and Indonesia, for example, if you have a stock of taxis that run on Uber or on other softwares, and if you have internet banking or phone banking, that simply means that they don’t really need as much physical capital as before to deploy, because they can do things far more efficiently by skipping the generation.
And if you think about what that means is also they can run much larger savings investment gaps in order to generate the kind of productivity that you require, a lot more capital for in the past. So I think the key here will be productivity. If you’re able to generate enough productivity in your economy, your financial assets, your economy, and your convergence with the rest of the economy—regardless of whether it’s Japan or it’s Indonesia—the story, the paradigm, that will need to be dealt with, will still remain the same.
Manoj, you’ve given us a lot to think about, so thank you very much for your time today.
Thank you. Thanks a lot guys.
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