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The Economics of Aging Populations

In the USA, President George W. Bush has launched his second round of tax reductions in order to stimulate the sluggish economy. Indeed, the economy shows signs of revival but it is difficult to attribute the improvements to prior reduction of taxes because they are essentially a macroeconomic tool of long term significance and limited short term impact.

In Germany, Chancellor Gerhard Schroeder is following President Bush's example by also proposing a round of tax cuts. Will they serve the intended purpose of reviving the economy?

On both sides of the Atlantic, interest rates have been lowered; in the USA more strongly than in Europe. Low investment costs are supposed to encourage innovation and expansion.

In Japan, the government has nearly bankrupted itself by spending huge sums on public works and other activities meant to revive the economy which was caught for years in a downward spiral of deflation. Interest rates have become negative. Several rounds of lavish debt financed public spending utterly failed to pull the economy out of the doldrums. But now that the government cannot spend anymore because of the huge debt it incurred in past years, the Japanese economy has resumed growth. Banzai!

In the countries that adopted the euro currency, the euro zone, a stability and growth pact (Maastricht pact) limits the acceptable annual public deficit of its members to 3 percent of GDP, and acceptable levels of inflation to 2 percent per year. Provided all members would adhere to these rules (which they don't), the euro zone would enjoy remarkable stability. But where is the growth?

In the 1980s and 1990s, the European Greens said that zero growth of the economy was desirable because Europe was already affluent enough, and zero growth was needed to protect global resources and the climate. Now that they have achieved zero growth (give or take a percent) they don't like it anymore.

Now even the Greens are praying for a little growth to replenish the government's coffers and help fund the comfortable social security and welfare levels offered to the people in the golden past.

Europe is not considered affluent enough anymore and all political parties dream of matching America's rate of growth, an impossible to achieve goal, as they sadly realize. Even the Greens have now convinced themselves that a little growth would not destroy global resources and the climate, provided the poor countries do not claim too large a share of the global commons.

All these divergent ways of trying to direct the economy by applying macroeconomic tools such as tax reduction, lowering interest rates, deficit spending or maintaining monetary stability have one thing in common: they are based on classical economic theory.

Yet, on the whole, these economic policies have been remarkably unsuccessful. The euro zone is still deeply distressed; the US economy shows signs of bouncing back mainly thanks to continuing strong private consumption and a housing bubble caused as a side effect of cutting interest rates, and Japan is getting back on its feet after the government had exhausted its macroeconomic arsenal.

What is wrong with classical macroeconomics?

Nothing probably, but the homo oeconomicus who is supposed to follow the rules has changed. He seems to have become more homo and less oeconomicus in recent years and decades. He shows irreverence by ignoring some of the sacred rules on which classical economics are founded. The secret of this change is hidden in the demography.

Basically, we can distinguish four types of demographic structure of a population, and each one is likely to react differently to macroeconomic stimuli and policies.

1. A very young society with over 50 percent of the population under 20 years of age, typical of developing countries.

2. A fairly young society which is still growing thanks to natural fertility and immigration, typical of the USA and Canada.

3. A medium old society which, because of low fertility, is relying on immigration to maintain its size, typical of Germany and Britain.

4. A rapidly aging society with very low fertility and not enough immigration to maintain size in the long term, typical of Italy and Japan.

Taking these differences into consideration it becomes obvious that different populations will react differently to macroeconomic incentives.

Basically, a prevalently young population has a high share of people who are busy building their livelihood and rank in the society. They are ready to work hard and accept sacrifices for their individual progress.

A prevalently old population has a large share of persons who have already defined their position in the society, who are happy with or have resigned to the levels of income and property they have achieved, and are neither willing (or no longer able) to work hard nor ready to accept sacrifices.

Offering a tax reduction will trigger opposite reactions in these populations. The young ones of the type 1 and 2 will grasp the opportunity and try to exploit it to enhance their personal growth. These young populations can be considered ‘expansive.'

The same tax reduction is unlikely to achieve much impact in prevalently old populations of the types 3 and 4 because of their essentially ‘defensive' attitude. They are more interested in defending their individual status quo than in taking action to improve it. The tax reduction will be absorbed as a welcome gift and probably turn up in the savings accounts rather than stimulating additional action.

Given the ranking of the USA in class 2, President Bush's rounds of tax reduction (if they can be funded without excessive levels of debt servicing) will probably prove to be quite powerful stimuli of the economy.

Chancellor Schroeder's tax reduction, however, might fall into a void and bolster private savings at the expense of higher public debt and excessive costs of future debt servicing because the German population is firmly anchored in category 3.

Out of 56 million Germans between 15 and 65 years of age, only 36 million, or 65 percent, are working. One third of adults is either unemployed (4.5 million), unable or unwilling to work. A total of 46.5 million or 57 percent of all Germans are either children, non-working adults, or retirees.

If we assume, for simplicity's sake, that one third of all working Germans are either too early or too late in their career to be able to make personal use of a tax abatement incentive, we are left with only 24 million working Germans for whom a tax reduction scheme could mean a stimulus. All other taxpayers, including retirees, would just pocket the gift.

Once we accept that the same macroeconomic tools might work quite differently in different types of population we can ask the next question: if, in an aging population classic macro tools don't work or even yield perverse effects, do we have to develop a different macroeconomic theory and policy for these populations?

In short: how can ‘defensive' populations be economically stimulated? Can we recommend something better than, for instance, tax reductions to Chancellor Schroeder and his colleagues in similarly situated nations?

If it is true that ‘defensive' nations show reactions opposed to those of ‘expansive' nations, maybe the exact opposite of classical macroeconomic tools will work in ‘defensive' nations. Instead of lowering taxes, Chancellor Schroeder would have raise them. Instead of monetary stability, Germany would perhaps need a hefty dose of inflation.

The purpose of these drastic interventions would be to shake ‘defensive' populations out of their complacent acceptance of the status quo by threatening to diminish their levels of income and property, thus forcing them to defend their position by indulging in additional economic activities. At the same time, the government should create an institutional framework encouraging these additional activities.

Raising taxes and creating inflation in a period of economic stagnation does not sound like a recipe for political survival of the government involved. But in reality, the recipe might not be as brutal as it looks at first sight.

In the case of the euro zone, the inflation possibly needed is already there even if the statistical services tend to ignore it. Ever since the introduction of the euro in January 2002, European populations complain about persistent inflation no matter how low the official rate looks.

In other words: it does not matter how high the official inflation rate is as long as the psychological rate at popular level of perception is high because this will trigger defensive action. All the government needs to do is joining the population in its complaints about inflation instead of trying to minimize it and negating the introduction of the euro as the triggering event, as Italian President Carlo Azeglio Ciampi recently did. Once the government decries the inflation and blames the euro for part of it will start to be in tune with the population, assume credibility, and help create a climate conducive to defensive action.

Raising taxes rather than abating them is not as difficult as it may look. In a stagnant economy, the government is hit by a stagnant or, more likely, shrinking tax base while faced with steeply rising expenditure for social security and welfare. The resulting deficit calls for tax increases, and rules of good budgetary stewardship such as the European stability and growth pact can serve as a perfect justification for introducing new and higher taxes. Also, there is some empirical proof that tax increases in stagnant situations have indeed helped an economy shake off the lethargy.

Again, the government would be well advised to enhance the psychological impact by stressing the significance of the tax increases rather than minimizing it (as governments usually do).

Even if there is some logic in trying a bold new approach to dealing with economic stagnation in aging populations it should, at the same time, not be ignored that this new approach would be at best painful if it succeeds but disastrous if it fails.

On the other hand, governments may not have much choice but walking the high road if all the low roads have led nowhere.

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—— Heinrich von Loesch