It’s the Demography, Stupid

11 November 2014

(See also the post Demography Charts – 1)

America’s anemic recovery can be explained by its slowing demographics.

Politicians tend to overstate the positive impact of their policies on the economy and to also exaggerate the negative impact of their opponents’ policies. In all likelihood, there are other more potent factors at work.

Instead of GDP, we look at wealth creation as the main measure of the economy. GDP measures economic activity which means that building roads to nowhere is a positive contributor to GDP in the near term because of the jobs provided and the material and services purchased. But building roads to nowhere is a waste of money. By contrast, wealth creation accounts for the return on invested capital and differentiates between good and bad projects.

And wealth creation has three main drivers: innovation, demographics and the economy’s institutional framework.

To illustrate the importance of innovation, consider a country where there is little innovation and therefore little creation of intellectual property assets. The main assets in such an economy are hard assets, such as real estate, natural resources and the like. Unless there is strong demand for these assets from foreign markets, the economy of that country would stagnate or grow slowly with its population. Good examples of such countries today are commodity economies like the leading oil producers, industrial metal producers etc.

Now consider a country where there is innovation but where the population is small. Here the amount of wealth created by innovation would be quite small unless there is strong foreign demand for the products and services brought about by that innovation. A new iPhone that can only be marketed to a small population would create a lot less wealth than one marketed to a large population. Good examples are Switzerland and Finland which are quite innovative, have relatively small populations but export their products in large quantities.

Innovation is back.

Innovation is back.

Finally, consider a country that has lots of smart innovators and a large population but that suffers from a poor institutional framework. It is a country where the government and citizens are corrupt, where contract law is nonexistent, where capital markets are small, where property rights are not protected. There would be little wealth creation in such a country because the innovators would emigrate to another country where they could more readily prosper from their innovations.

Since 1945, the United States has been blessed by all three major contributors to wealth creation: strong innovation, strong demographics and a stable and supportive institutional framework. The same has been true for Europe, albeit with slower innovation and slightly worse demographics. The same has been true for Japan, with still worse demographics.

So where do we stand today? Of the three main engines in the US, innovation and the framework are still going strong. But demographics have weakened in several ways. First, after declining for several decades, the dependency ratio (number of dependents per worker) has been rising since 2005. Second, the number of Americans aged 30-60, arguably the most economically active age bracket, has stagnated at a little over 120 million people. Previously, the 30-60 group had grown steadily in every year from 1978 to 2005.

Presidents Reagan and Clinton are credited with a successful economy but their years in office also benefited greatly from a falling dependency ratio. The same is true for the second President Bush until mid-decade when the dependency ratio bottomed out and started to rise.

The anemic recovery since 2008 can largely be explained by our deteriorating demographics. The US population used  to grow by 1 to 2% every year, which meant that companies could count on real growth of 1 to 2% and another 2 to 4% of inflation. But since 2007, annual population growth has fallen below 1% and inflation has also fallen. So what used to be safe annual domestic revenue growth of 3 to 6% is now looking more like 1 to 3%.


In Europe too, the dependency ratio bottomed and started to rise in the middle of the 2000s decade. In addition, Europe has been less innovative than the US in the past ten years, which explains its stock market lagging the US market. The rise of Google, Facebook and others and the resurgence of Apple have all taken place in the new millennium. Europe has had no such large success stories. Worse, one of its former superstars, Nokia, has nearly disappeared. So Europe still has a strong institutional framework but its other two engines of wealth creation are sputtering.

Japan’s dependency ratio bottomed in the early 1990s which may explain the country’s stagnation since then. It remains highly innovative but perhaps not sufficiently so in new focused companies with higher returns on capital.

The lesson of recent years is that US innovation may be strong enough to counter the effect of weakening demographics, but not strong enough to produce strong GDP growth. In addition, revenue growth in several industries has become highly dependent on exports to emerging markets. The economy and markets will do well if export demand continues to grow. But if emerging economies experience an important slowdown, our worsening demographics means that there will not be sufficient demand at home to pick up the slack.

For more data on US and world demographics, please refer to these previous posts:

The Economy’s New Boss: Demographics

Is America Heading Towards Zero Population Growth?

European GDP: What Went Wrong

Demographic Megatrends of the 21st Century

US Demographics and Housing

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