Ape Man

As part of their work on the Fertility Trap Hypothesis, Edward Hugh and Claus Vistesen argue that an aging demographic profile will lead to an export-oriented economy. More controversially (at least to me), they argue that a move towards an export economy will make it hard to raise birth rates to replacement levels. They think that the process of moving towards an export-based economy will put pressure on wages of young people which in turn will make them less likely to have children.

Mr. Hugh and Mr. Vistesen’s argument revolves around the Life Cycle Model of consumption and savings. The special twist that Mr. Hugh and Mr. Vistesen bring to the idea of the Life Cycle Model is that it can explain things on a macro level based on the demographic profile of the country in question.

Now there are many ideas in the Fertility Trap Hypothesis that I think are quite strong and likely to hold up across all cultures. But I don’t think the Huge and Vistesen’s work with the Life Cycle Model will be one of the successful ideas. I see no reason to think that fertility will be negatively affected even if savings/consumption behaves as the Life Cycle model says that they will. In other words, even if the Life Cycle Model holds true across all cultures (a big if, that), the economic effects that will result are not part of the “Fertility Trap.”

It’s a little bit cheeky for me to say all that. After all, Mr. Hugh is macroeconomist with many years of study. And though Claus Vistesen is still a student, he has done far more studying on this matter than I have. By comparison, my background as an ignorant hillbilly means that my credentials are a little thin for tackling such issues as the Life Cycle Model of consumption and savings and how it relates to demographic age structures on a macro scale.

But Mr. Hugh’s response to a comment I made over at Vistesen’s blog has stirred up my thinking on the issue. So in between trying to get over sinus issues (otherwise known as the common cold, apeman style), trying to fix my truck, and trying contribute my fair share towards getting a garden in, I have been pondering Mr. Hugh’s and Mr. Vistesen’s idea.

In an effort to get this issue off my mind, I thought I might share with the world some of my thoughts on Hugh’s and Vistesen’s idea. I should warn everyone that the following is going to be long on theory and short on facts. I think that the facts generally support what I am trying to say, but I don’t have time to dig up the supporting data that I have read in the past to make sure it really supports what I am trying say. In other words, I am being an ass, but I know I am being an ass.

Anyway, the beginning of my approach to Hugh’s and Vistesen idea was an attempt to formulate a model that would help me understand it.

Now the way that I attempt to understand any complex idea that is new to me is through the formation of thought models. In other words, I take the simplest concept that I can grasp out of the complex idea that I am trying to understand and I try to imagine how that concept works in a simplified imaginary world. Once I have gotten the feel for how the simple concept works, I then try to add in the complexity that is found in the original idea to see if I can understand it. I also try to add in the complexity that I observe in the real world if I feel that complexity is lacking in the original idea.

My goal in doing this modeling is twofold. First, I want to understand the complex idea and second, I want to come to a determination of the idea’s validity.

So to formulate a simplistic model of what Hugh and Vistesen were talking about, I started with a simple assertion that there are economic forces that drive economies with an older demographic profile towards a situation where they run a trade surplus.

And what is a trade surplus? It is the trading of domestic consumption and investment for international assets.

Once I had my basic concept, I started thinking of ways that I could model a situation where a country with an older demographic profile would feel pressure to run a trade surplus.

First, I made the observation that throughout history the old have always invested in capital to take care of themselves in their old age and the young have always worked that capital. For example, if you were a tribal nomad raising sheep and goats you would gradually pass the work of taking care of the sheep and goats onto your children. But they would still be your animals and you would still make your living off of them.

In a similar manner, people in a modern economy invest in stocks and bonds that provided capital for the younger people to work with. People in a modern economy expect those stocks and bonds to keep supporting them long after they are unable to work like they could when they were younger.

Having made this simplistic observation, I decided to use an imaginary group of Nomads to model the simple concept that I pulled from Hugh and Vistesen complex idea. I started by saying…

What if there were two nomadic couples who were raising sheep together (4 people total in case I am not clear). Let us say that one couple has a boy, the other couple has a girl (2 additional people) who are going to be married to each other. Let us say that our hardworking nomads have no more children because they are too busy trying to get wealthy by increasing their flocks. Let us say that they are spectacularly successful and they acquire a huge flock.

Now here is the problem. There are now 3 couples (6 people in total) that need support from this flock. None of the couples want their living standard, which they worked so hard to achieve, to go down. But it is getting harder for the two older couples to work the flock efficiently. They can foresee a day when they won’t be able to work it at all. Assuming that they don’t want to let any outsiders into their tribal grouping, how can they make sure that their living standards don’t fall? After all, the younger couple can’t pull the weight for all of them.

The obvious answer is that they can send their sheep out to be raised by other tribal groupings in return for guarantees of future support. In other words, they would have a trade surplus with the other tribal groupings.

Now I could easily imagine thats type of thing applying to a modern economy with serious demographic imbalances. After all, modern capital needs to be used and watched over by real people no less than the sheep of old. And sheep + nomad labor = food, clothing, shelter, and more sheep just as capital + labor =equals all the material things that we want and need as well as more capital.

Moreover the law of diminishing returns suggests that that there is only so much capital that one person can handle just as one person can only take care of so many sheep. In other words, all other things being equal, you will get a better return on capital by investing $100,000 in 10 different people, than you will by investing 1 million in one person (I am talking about the real economy here, not financial markets. So the capital I am talking about here would be tools, office space, and such). Past a certain point, you will not be able make any kind of return by giving people more capital to work with.

It stands to reason, then, that the investments needed to maintain the standard of living in a country with an unbalanced demographic profile would outstrip said country’s ability to absorb that investment efficiently (I am leaving technology out of this for now), just as they do in my little nomad model. Thus, I could see how pressure to prepare for retirement might lead countries with aging demographics to run a trade surplus.

Now at this point in my thought process, I had reason to want to explore Hugh and Vistesen’s idea further. The idea that countries with an aging demographic would be under pressure to run a trade surplus at least seemed plausible. But I still did not understand many of the claims that Hugh and Vistesen were making. So I put on my thinking cap and I pondered my model in greater detail.

When I start off with my models, I like to keep them as simple as possible because it helps me see the obvious points before I burden my poor little brain with complexity. So my next step was to try to think of all the obvious points inherent in my model.

The first thing that was obvious was that in order for my demographically challenged group of nomads to ship sheep off in exchange for future support they need people they could ship the sheep off to.

Now what does this need for other people imply? First off, it implies a need for people that my little nomad group can trust. After all, what is the point of giving sheep to a people that you don’t think will support their end of the bargain?

It also implies that there needs to be other people out there who can handle the sheep that our nomadic group is sending their way. More importantly, they must be able to do so more efficiently than my overburdened nomadic group. In other words, the “other people” need to be able to make a return off those sheep that will enable them to give my little nomadic group some kind of return, and they need be able to get enough out of the sheep to compensate themselves for their labor.

This implies that there must be other groups out there who have at least some sheepherding skills, and yet do not have enough sheep to max out their productive capacity (at least relative to our little nomadic group. This is an important point I will return to) in order for our little nomadic group to be able run a trade surplus.

At this point I stopped to ponder how my model might equate to the real world.

It seemed obvious to me that in the real world the matter of trust is very important. Lots of people in other countries want to buy US treasuries and yet demand for the bonds of third world governments is not quite as high. I think that it is fair to imagine that this has lot do with trust, just as our little nomadic group’s willingness to send away sheep in return for future support would have a lot to do with trust.

I think that it is also fair to say that the problem of finding people with capacity to handle the sheep also has its real world counterpart. People generally want to invest in the US or the Asian tigers as opposed to Middle East or Africa. In part this has to do with the issue of trust, of course. But the trust issue aside, it is tough to build computer chips where there is widespread illiteracy and non functioning governments.

All this implies that in real life there are limits to the export strategy. The whole world can not have a trade surplus. The figures have to balance out (as a matter fact, they don’t, but that is because statistics don’t encompass all economic activity. The principle is still valid). This implies that there must be economies that can handle the extra capital and are also trusted by other countries in order for trade surpluses to be a viable strategy to help cope with an aging demographic profile.

To expand upon this point: The very theory that implies that a country with an aging demographic profile will try to export capital implies that there is a limit to the capital that a country with a younger demographic profile can efficiently absorb. After all, the whole reason that my little nomad group wants to send sheep out to be raised elsewhere is because the young couple of their group can only handle so many sheep.

Now this all might seem so obvious as to be silly. But if you stop and think about it this is actually really depressing if true. Because in the real world more then half the world population fertility is below replacement rate and the rest of the world’s fertility rate is dropping fast. Moreover, those places that have not already dropped below replacement rate are mostly in Africa and the Middle East. Those are not places that most people would feel comfortable investing their retirement savings.

This implies that if countries with an aging demographic profile really do need to invest in other countries to keep their living standards up, then a lot of them are plumb out of luck. Their simply won’t be enough countries with a younger demographic profile to absorb the needed investment. Such a depressing conclusion warranted more thought. It was time for me to add more complexity to my model.

Up until this point I have left out the idea of productive capacity out of my model. In other words, I have been assuming that the young couple in my nomadic group will only be able to handle as much sheep as their parents did at a similar age. But this assumption does not necessarily hold true in the real world. Technological changes can increase people’s productive capacity.

Thus, given more advanced technology, a smaller working population could produce the same output as a larger working population. The effects of technological progress can partially (or fully?) offset the effects of the law of diminishing returns.

To bring that back into the context of my nomadic model: What if my nomadic group bought some horses and a couple of really good sheep dogs? Won’t the extra productivity allow our nomadic group to maintain their living standard even as their work force drops? Theoretically, there does not seem to be anything that would rule this out. But let us stop and think about the implications of this for a little bit.

The first and most obvious implication is that technological advancement would not raise the living standard of my little nomadic group unless I imagine a really revolutionary technological advancement. Otherwise, all of the extra benefits of the technological advance would be needed just to maintain the existing living standard. In fact, the demographic shortfall that my nomadic group faces means that they need an extremely high rate of productivity advances just to keep living standards from falling.

Another implication of adding technology into my nomad model is not so obvious. Remember that sheep stand for capital in my little nomadic model. Let us observe that for our little nomad group technological advance does not really become necessary until the amount of sheep becomes greater than they can handle without the aid of horses and such. In other words, your ability to adopt more advance technology is dependent on the amount of capital you have in my simplistic nomad model.

Roughly speaking, this is why countries start out making shoes and work their way up to chip fabricators. It takes a lot more capital relative to labor to make a chip fabricator than it takes to make a shoe factory. Thus, it usually makes no sense to try to use advanced technology unless you already have large capital stocks relative to your amount of labor.

But what if you are like my little nomad group and you are facing a future labor shortfall? Maybe you would want to leap frog far above the technological level your capital level can support now so as to arrive at a productivity level that would enable you to support your living standards with a reduced worker-to-dependent ratio.

In other words, we can imagine that our little nomad group might want to import more sheep if that was necessary to support the use of horses (horses standing for acquiring of advanced technology as opposed to just increasing your capital stocks). In this case our little nomadic group would be running a trade deficit even though they had an aging demographic profile.

But for this to work, it would depend on the other nomadic groups out there already having maxed out the technology available to them and operating with more sheep than they could handle efficiently. In other words, they would have be making a smaller return with their sheep(less costs) than my little nomad group could potentially get. Otherwise there would be no one willing to send my little nomadic group extra sheep because everyone would be advancing their own productive possibilities.

Moreover, my little nomadic group would have to make enough to pay for the cost of the horses, pay off the cost of borrowing extra sheep, and make a return on top of all that sufficient to make the whole exercise worthwhile.

The implications of this for the real world seem to be that countries that are already developed cannot look towards technology to bail themselves out of an unbalanced demographic profile. If we assume that ever advancing technology allows for a 2% yearly increase in average productive potential, then demographic change must be below 2% a year in order for technology to make up the gap. Countries like Japan and Germany, which are changing their demographic profile at a rate greatly in excess of 2% are going to need to look for some other solution in order to prevent a drop in their living standards.

In some cases, though, it might be possible for a developing country with a unbalanced demographic profile to maintain living standards by adopting new technology. But this is not as good as it sounds. Developing countries normally look to technology to raise their lifestyle to the level of a first world country. But if they have an unbalanced demographic ratio they could be adopting technology just to maintain their already low living standards.

Taken so far, it seems that countries with an aging demographic profile might indeed be pressured to seek investment opportunities in other countries. Such opportunities might not always be forthcoming given the aging of the world’s demographic profile. But Huge and Vistesen acknowledge that this might be a problem.

So what is my problem with Huge and Vistesen’s idea? It seems so far our little thought experiments have supported their contention that an export-oriented economy is a natural feature of an aging demographic. But that is only half of Huge and Vistesen’s idea. The other half of their idea is that this process would lead to lower wages for young people and thus discourage them from having children. The idea is that this process is self-reinforcing. This is why they want to add it to The Fertility Trap Hypothesis.

This is where I get lost. No matter how I run my little nomad model and no matter what other models I try to create, I simply can not understand why this process should lead to lower incomes for young people. In fact, most of my thought experiments seem to indicate that if any thing, wages for young people should rise.

Now, that is not to say that I can’t see other ways that an unbalanced demographic would put downward pressure on wages for young people. Higher health care costs associated with an aging demographic and a universal health care system would be one such example. In that system, cost would be spread over all the workers, but the benefits would be going primarily to the elderly. The effect of this would be to depress the wages of young people relative to wages of previous generations of young people.

But Hugh seems to think that the changing mix of consumption and investment associated with an aging demographic would negatively affect young people. He says….

In order to compete for exports these economies have a permanent pressure on their tradeable sectors, whereby outsourcing is continuous and ongoing, wages are continuously compressed, and structural reform is permanent. Since the very export dependence is only further reinforced by the continuing process of change in the population pyramid (ie domestic demand never “recovers” as such) this is all self-reinforcing. That is the more time passes the more there is downward pressure on the wages of young people.

In a different post Vistesen says…

And this dear readers is where demographics come in and more specifically why we need to look at the population structure of for example Germany and Italy in order to really understand what is going on before our eyes. Why for example is consumer spending persistently low in these two countries and why is Germany running a trade surplus of 6% of GDP.

The common theme in Vistesen’s and Hugh’s argument seems to be that an ageing demographic will consume less as a percentage of their income and thus younger people will have less job opportunities. But as far as I can puzzle it out, even if you grant their premise, their conclusion does not follow.

Let us go back to my nomad model for a bit. If my little nomad group ships out sheep in return for promises of future support, that is going to reduce the amount of lambs that they are going to get in the coming spring. Less sheep=less lambs.

But this is not necessarily a loss. If you have more sheep than you can efficiently take care of (which is why they want to send sheep away, remember?) then you might have less lambs the following spring anyway. Thus you might not necessarily be losing lambs by sending sheep away.

Now I think that this applies pretty well to a modern economy. All other things being equal, those nations that export capital are going to have a slower growth rate than those who import it. True, you expect to get a return on that exported capital. But in the short term, that return is only a fraction of what you paid out (i.e if you get a 7% return on your money, it is going to be a while before you get your hundred dollars back).

Thus I can accept nations that run trade surpluses will have slower GDP growth than those that don’t (all other things being equal). And I accept that slower GDP growth means less job creation (all other things being equal). But how is this a problem for a demographically challenged society?

The problem that leads a demographically challenged society to export capital is that they don’t have very many young people. That means they don’t need to create very many jobs. But that does not mean that the jobs that they do create pay less. In fact, given that young people have a competitive advantage at many tasks, one would think that a shortage of young people would actually cause their wages to rise. (Granted, older people have a competitive advantage at many tasks as well. But there would be an abundance of them.)

In short, domestic consumption does not have to be as robust in order to provide sufficient employment for the younger cohort in a demographically unbalanced economy.

Hugh argues that trade puts pressure on wages. So, by his reasoning, when you work in exports, your paycheck is always under pressure. I am skeptical of this line of reasoning, but even if it is true that working in exports puts pressure on wages (which does not seem to be the case from what I have read), this is not really an issue related to demographic saving patterns. One would expect that if people in other countries could make something cheaper that it would affect the wages of young people regardless of whether the demographic profile was aging or not.

Hugh and Vistesen’s strongest point in their favor is the real world data showing that incomes for younger people have dropped when compared to their parents at a similar age. But this is very misleading data.

The proper data for Hugh and Vistesen to base their claim on would be to compare the total cost to the employer of each hour worked by the younger generation and the older generation at a similar age. I strongly suspect that with the rise in pension costs, health care costs, increased labor regulations, and greater vacation time, that you will find that young people around the world are costing their employers more than their parents did at a similar age. I suspect that this would hold true in Japan and Europe in particular.

To be sure, this does not take away from the fact that young peoples’ wages are dropping. And the fact that their wages are dropping could very well be a contributing factor in the lowering of fertility rates. But if young people are costing their employers more than their parents did at a similar age, then I think that you can hardly blame an export-oriented economy for putting pressure on their wages. Instead you must look to those things that are causing their labor to be so much more expensive than their parents at a similar age.

The long and the short of this is that I can see an aging demographic profile leading to a trade surplus. But I don’t see this as being something that contributes to “The Fertility Trap.” Rather I see it as the last hope of many countries to get out of the “The Fertility Trap.” And as the world ages, that last hope is going to fade fast.

This entry was posted on Monday, May 28th, 2007 at 6:41 pm and is filed under Demographics, Economics, Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.