BY JUAN F. JIMENO
After the Great Depression and the subsequent European debt crisis, the European economy seems nowadays to be gaining some momentum. Yet there are structural factors that could make the recovery sluggish and keep unemployment persistently high. These structural factors are population ageing and declining working age population, low productivity growth, and the public and private debt legacy of the crisis. The interaction between these factors could make the full employment equilibrium unattainable, leaving very little room for macro demand policies – monetary and fiscal – to play their stabilisation role.
In what follows I briefly explain the nature of the persistent stagnation that could be generated by these structural factors. It is not only that the European economy is bound to grow less than in previous decades because potential growth would be lower from the slowdown in population and productivity growth. It is also that actual growth could be below potential due to a permanent shortfall in aggregate demand (Summers, 2014). I start by discussing why potential growth may be lower in the forthcoming decades. Then I refer to the macroeconomic model that rationalises a persistent stagnation trap with a permanent shortfall of demand of the nature described above. I conclude with some final remarks on the policies needed to make this gloomy scenario less likely.
The slowdown in potential growth
There is a lively debate among macroeconomists and economic historians about the likely evolution of potential growth (see Baldwin and Teulings, 2014). The main issue under discussion is technological progress. The pessimistic view is that the recent technological revolution – mostly spurred by the introduction and dissemination of new information and communication technologies – has already delivered all of its potential to speed up productivity growth. The optimistic view is not only that this potential is far from being fully exploited but also that new discoveries – through avenues such as the progress of robotics and artificial intelligence – will make it possible for productivity to grow, at least at similar rates as during the 20th century.
Of course, settling down which of these two views is right will require some time, as ‘prediction is very difficult, especially if it is about the future’. In any case, the recent experience during the last decade points to two elements that do not sustain very optimistic expectations. First, capital accumulation and total factor productivity growth, the two driving factors of labour productivity growth, have significantly slowed down since the mid-2000s in most developed countries (Figure 1). Secondly, productivity growth during the last two decades seems to be more labour saving and biased to skilled labour than previously. This has generated some employment polarisation, so that unskilled workers have benefitted much less from the technological progress and labour earnings inequality has significantly increased. Were future technological progress to reproduce these patterns, income distribution would be an even greater concern than it has become recently.
Figure 1. Capital-Income Ratios and Total Factor Productivity
Demographic prospects are less debatable. The size of the working age population in many developed countries is already shrinking. The fall of fertility rates in the last decades also implies that the decline of working age population will continue well into the 21st century (Figure 2). This decline could be lessened by increasing immigration and retirement age but it is important to notice that there is substantial socio-political resistance to immigration in Europe. As for increasing retirement age, given the current and expected age structure of the European population, there is very little that this measure can do to change the ratio of the size of the retired population cohort to working age population. In sum, working age population in Europe is bound to decrease and it is almost inevitable that the ratio of retired population to the working age population is likely to double over the next three decades.
The decline in working age population and the rise of the weight of non-active population have many important economic consequences, directly through its impact on the absolute size of the economy, and indirectly, since many macroeconomic variables depend on the ratio of the working age population to the total population (see Aksoy et al., 2015). A first consequence is lower potential GDP. Secondly, population ageing may also slow down labour productivity growth through less capital accumulation and less innovation, so that GDP per capita growth may also decrease.
Adapting to a lower potential growth scenario will not be a major economic problem in a context of lower growth. However, insofar as GDP is diminished, incomes to pay debts will be lower. Moreover, due to the burden of debts and to the extent to which expectations of income growth are diminished, savings would increase pushing the equilibrium real interest rate down.
Figure 2. Demographic trends in Europe.
Source: United Nations, Population Division.
An ugly macroeconomic regime
A possible consequence of low potential GDP growth is that the equilibrium real interest rate may reach levels that cannot be accommodated by the existing macroeconomic policy tools. When this happens, to the misgivings of low growth there is the additional danger that actual GDP could be persistently below potential and unemployment could be persistently high.
As hinted above, lower potential GDP growth makes it more likely that the equilibrium real interest rate reaches levels below what conventional macro policies – monetary and fiscal – can deliver. This is so because lower potential growth implies higher savings and lower investment so that the real interest needed to accommodate the equilibrium may even be negative. Since the nominal interest rate cannot fall significantly below zero and cannot stay in negative territory for long periods, the real interest rate could be too high for the full employment equilibrium to be attainable. There may also be a vicious circle operating: as the real interest rate is too high, aggregate demand is too low, and as inflation decreases, the real interest rate becomes even higher (Jimeno, 2015).
There are several reasons why savings are increasing. First, the decline of the young population implies less demand for credit. Secondly, uncertainty on expected income growth leads to higher savings by the middle-age population. This uncertainty arises from two sources. One, already discussed, is the concern about the path of technological progress and, hence, future productivity growth. Another is that pension systems, the main source of income during retirement, appear to be overburdened. It is unlikely that pensions will be able to deliver on promises of replacement rates (the ratio of income during retirement to labour earnings), especially under the gloomy demographic prospects. The debt legacy of the crisis is another factor decreasing consumption of this population cohort, since they have to reduce consumption to meet past debt obligations. A countervailing force towards increasing consumption is the increasing weight of the old population, which by depleting their savings should increase consumption. However, so far, this factor is not a significant one in the data since the increasing size of the current cohort of retirees is not contributing much to consumption.
As for the decreasing demand for investment, there are several driving factors. One is that the relative price of investment goods shows a very marked decreasing trend, so that lower funds are needed to sustain the desired capital stock. Secondly, as the working age population shrinks, less capital is needed to reach the desired capital-labour ratios. Finally, less demand causes the desired capital-labour ratio to diminish.
In this context, it seems likely that the European economy is bound for a long period of very low equilibrium real interest rates. Whether it falls in the kind of persistent stagnation described above is a controversial issue but, in a context of very low interest rates, any negative shocks could push the interest rate compatible with the full employment equilibrium into a territory out of scope for conventional monetary and fiscal policies. In this regard, it is important to realise what fiscal policies can and cannot deliver when it comes to regulating aggregate demand. If the diagnosis above on the factors leading to higher savings is right, then the only way that fiscal policy can alter aggregate demand is by changing intergenerational transfers, that is reducing the private and public debt burden on younger cohorts, at the cost of diminishing transfers to the retired population. However, this is becoming less and less politically feasible as the weight of the retired population increases.
The significant decline in working age population and the large increase of the retired population can only be compensated by higher productivity growth. Recently, productivity-enhancing structural reforms are being strongly advocated by many international organisations and policy institutes. According to the diagnosis in this paper, the fact that these structural reforms are again receiving so much attention is very much justified.
Aksoy, Y., et al. (2015), “Demographic structure and the macroeconomy”, VOX, available at http://www.voxeu.org/article/demographic-structure-and-macroeconomy
Baldwin, R., and C. Teulings, eds. (2014), Secular Stagnation: Facts, Causes and Cures, CEPR Press and Voxeu.org.
Jimeno, J.F. (2015): “Long-Lasting Consequences of the European Crisis”, ECB working paper, #1832, July.
Summers, L. (2014): “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound”, Business Economics, vol. 49, 2, pages 65-73.