Initially published at Seeking Alpha on Wednesday, December 3, 2008.
Note: The ratio described here and shown in the chart is the inverse of the dependency ratio.
The future state of the US economy depends to some degree on the demographics of the United States. Demographics are not everything in the world of economics and investing, but they can be an important determinant of growth. For example, the maturing of baby boomers in the 1980s and 1990s combined with the technology revolution, the Reagan tax cuts, and the declines in commodity prices and interest rates, produced a powerful cocktail which propelled stocks 14-fold in the 18 years between 1982 and 2000.
A useful measure of demographic change and its impact on the economy is the number of economically active people relative to the number of inactive people. If, for example, 75% of the population works and produces while the other 25% studies or enjoys retirement, the economy will fare better than if only 50% produces while the other 50% studies and cruises. The active population creates the wealth and, directly or indirectly, supports the inactive or less active population.
Regarding the broader economy, it is useful to calculate a ratio of the economically active to the economically inactive. In our country, we could say that people aged 25 to 67 constitute the economically active population while people aged less than 25 or more than 67 are children, students, or retirees, are therefore inactive, and are dependents of the active population. These are broad assumptions but they are probably true enough to make our exercise reliable. (Using 18 years as a cutoff instead of 25 years does not materially alter the outcome of the analysis).
When the ratio of the active to the inactive is rising, the economy would grow and we would enjoy increasing amounts of discretionary income. Conversely, when the ratio is falling, there would be fewer workers and more dependents, and the economy would grow at a slower pace, or even shrink, and we would have lower levels of discretionary income.
Ratio of Active to Inactive US Population
A look at the adjoining chart is informative in this regard. The ratio of active to inactive had been growing for years until the middle part of the current decade, but it has started declining, gently for now but more steeply starting in 2012 and for the following 18 years. If you accept the premise of this analysis, this inflection is not good news for the economy in the next two decades. Other factors may intervene to mitigate this ratio, but the economy will be fighting a headwind which did not exist when the ratio was growing in the previous fifteen years.
Retiring baby boomers as a group are far wealthier today than their counterparts of previous generations. Their consumption can impact the economy positively long after their retirement begins. But the market value of their assets could also come under pressure due to this demographic picture. All other things being equal, a declining active to inactive ratio will impact adversely the asset values and net worth of all Americans.
The chart includes many assumptions. For example, the number of dependents who are under 25 years includes estimates of future births. In the base case scenario, we used a birth rate of 14 births per 100 women aged 20 to 35, a rate that is consistent with recent years. If the economy deteriorates, this birth rate could fall back towards its all-time low of 11 where it was in the late 1970s.
Politicians will be tempted to raise taxes on the active population to fund social security but this would be raising taxes on a segment of the population which will already be suffering from lower economic growth and falling discretionary income.
One clear, but politically difficult, solution is to raise the retirement age to 70 years. Social security was introduced at a time when life expectancy was significantly lower than it is today. Adding the 67-to-70 year-olds to the active group (and removing them from the inactive group) would delay the decline of the active/inactive ratio by six or seven years and would limit the overall burden placed on the active segment of the population by the inactive segment.
Foreign markets may help us mitigate the impact of these demographics. New workers in India, China and other developing nations cannot be expected to support our aging population. But foreign investors in American assets would help support asset values at a time when there could be more sellers than buyers in the United States itself. Avoiding a decline in asset values will help maintain consumption among retirees at levels which would be supportive of the economy.
In theory, immigration can be part of a solution. Large numbers of people are waiting in line to come and live and work in the United States. But the mood of the country is currently to limit rather than expand immigration, at least until a solution is found for illegal immigration.
A temporary combination of a lower birth rate, higher worker productivity, and a higher retirement age should be sufficient to get us through this difficult period. But relying on the status quo will lead to economic stagnation or worse.