The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival

Abstract

Before the 2008–2009 Great Recession, Europe and North America enjoyed over 20 years of economic stability. Economists called this period the “Great Moderation.” Inflation was low and stable, interest rates fell, and the business cycle seemed muted, especially when compared with the volatile 1960s and 1970s. Even after the Great Recession, inflation and interest rates remained low. Although economists disagree about why these years were tranquil, many credit independent central banks. If wise central bankers are responsible, we could rely on them to keep inflation subdued and interest rates low through any approaching storms. If not, and the stability’s true causes change, inflation and interest rates might skyrocket. In their fascinating book, The Great Demographic Reversal: Aging Societies, Waning Inequality, and an Inflation Revival, Goodhart and Pradhan question the conventional wisdom about the recent macroeconomic stability. They argue favorable demographics, not wise central bankers, best explain this period’s stability. Further, they contend demographics will be less auspicious in the coming decades. They predict this reversal will mean growth slows, inflation rises, debt explodes, and nominal – and possibly real – interest rates climb. The authors argue two phenomena helped tame inflation and keep interest rates low during this period: China’s reentry into the global economy and the developed world’s falling dependency ratio. China’s reemergence, which started in 1978 when it created its first special economic zones and reformed agriculture, helped Europe and North America in two ways. First, it provided the world with many unskilled and semi-skilled workers. Although this harmed European and American manufacturing, Goodhart and Pradhan argue it also diminished workers’ negotiating power and lowered the natural rate of unemployment (NRU). This, in turn, moderated inflation. Second, China’s high savings rate – combined with a fixed exchange rate and financial repression – kept interest rates low as China invested its foreign currency reserves in United States (US) Treasuries and other foreign assets. The industrialized world’s declining dependency ratio – the ratio of the elderly and children to the working-age population – also restrained inflation and interest rates. Because women started having fewer children in the 1960s in the US and most other developed countries, the dependency ratio remained low until the early 2000s despite rising life expectancy. Goodhart and Pradhan argue the low dependency ratio subdued inflation and interest rates because workers save more than dependents. Further, the postwar baby-booms’ boost to the labor force also kept the NRU low.