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

Nokia: The Path To Recovery

What this country needs is a good $99 smartphone.

That’s what Thomas R. Marshall, Woodrow Wilson’s Vice-President (1913-1921), might have said today instead of ‘a good five-cent cigar’. Smartphones are still very expensive, at least at the pre-subsidy price. Carriers pay over $600 for top-end phones and ‘subsidize’ customers who pay a discounted price if they commit to a multi-year wireless plan. But prices are destined to fall in the next few years. Within a decade, we could be looking at a $99 phone (pre-subsidy) which will approach the same functionality as today’s flagship phones.

Regarding their competitive strategy, there are two ways for smartphone producers to deal with this evolution.

1. A Top Product Strategy

One way is to start at the top with the best possible product and to continually improve its features. The flagship phone produced by each company can then remain at prices similar to today’s prices but its capability will grow year after year. This seems to be the strategy followed by Apple with each of its product lines. Each has a similar price as a few years ago but its functionality is much greater.

This strategy however has its limitations: at some point, whether it is in 2013 or in 2018, a majority of the buying public will not care as much about new features because the new phone’s capability will far exceed whatever need or use the consumer may have for it. Adding music and cameras was huge. Adding wifi was huge. Adding apps was huge. At some future date, they will be adding things that only tech geeks, or the few people who use their phones’ full capability, really care about. Even within the apps catalogue, most of us will truly care about only a dozen or so. And most of us are rarely more than thirty minutes away from our personal or work desktop computers. There are truly very few apps we ever need to use urgently, in less time than it takes to reach a desktop.

For companies with a product strategy, it is a challenge to keep people interested in new features. And it is a race against time to release these features on a schedule which will preserve high prices and high margins. In most such races against time, time ends up winning.

2. A Bottom Price Strategy

The other way for smartphone producers to deal with new competitive pressures is to start from the bottom with a preset price for a phone and to see how many features can be packed in at that price while the phone is still profitable. So say a company chooses $99 as a price before subsidies and it sets out to discover how good of a phone it can deliver at that price. The first few phones priced at $99 will look very inadequate. But here, unlike with a product strategy, time is an ally. The more time goes by, the better the $99 phone will become. In the future, a $99 phone will be as good as an iPhone 5 or a Samsung Galaxy S4.

Asha Rising.
Asha Rising.

The question then is which company would you rather be? Would you rather be the first company racing against time trying to slow down margin erosion by offering more and more features, while hoping that customers will still want them? Or would you rather be the second company, with time as an ally, securing a growing segment of customers who want a low price and who only use a few apps on a regular basis? In the early days of the smartphone, when new features addressed important market wants and needs, I would have to put my money on the first company and it made sense to invest in Apple. Going forward, I would have to put my money on the second company.

Industry Shift to Dumb Smartphones

This is where Nokia could make a strong comeback. I have no idea whether it will pull it off, but it has a plausible path to recovery. Nokia lost the first smartphone round to Apple and Android. It could gain market share in the high end with its Lumia Windows Phone 8 phones but this looks like a difficult proposition, as noted by many authors here. It is not enough for the Lumia flagship to be as good as a top Apple or Android phone; it has to be significantly better or its price has to be much lower to compensate for consumers’ inertia, brand loyalty and switching costs. You may not consider a top Lumia phone if it is $50 cheaper than an iPhone but you would consider it if it was $100 cheaper and if you are not too rooted in the Apple or Android ecosystem.

Within the Lumia range, Nokia recently introduced the Lumia 521 priced at $150 with no contract, but its margin on this phone is probably low, or possibly negative. The challenge for a ‘bottom price strategy’ is to deliver a low-price phone which is still profitable for the manufacturer. Entry level phones like the Lumia 521 may be unprofitable and positioned as loss leaders to gain market share and to attract buyers in the hope that they will later migrate up to more profitable phones.

Generally speaking, when comparing Lumia to iOS (Apple) and Android (Samsung and others), there is rarely room for a number three to prosper in a space that is dominated by two aggressive well-financed players. Lumia has been gaining market share but it has yet to break into double digits.

Instead of banking too much on Lumia, Nokia can instead win the next round when prices start to fall quickly, or to put it differently, when the functionality of inexpensive phones starts to rise quickly. That is why, of Nokia’s two recent phone launches, the Asha 501 was in my view the more exciting. Not because of the phone itself, but because of the strategic shift it may bring. While the industry’s heavyweights are battling to claim the title for the smartest smartphone, an increasing number of consumers will be satisfied with a low-priced ‘dumb smartphone’.

The Asha 501 is priced at $99 and its functionality is very limited today. See CNET’s video review of the Asha 501 and a review by TechCrunch. But as noted above, its capability is only going to improve in coming years. Launched in India, it will ship in June via 60 carriers in 90 countries, mainly in emerging markets and Europe, but not the US. Instead of Windows Phone, it uses the Smarterphone OS, a stripped down operating system, and runs on 2G GSM networks. Not exactly the kind of stuff that would get an American buyer excited. But at a future date, Nokia may be able to launch a much improved low-priced phone in the US. Of course, Apple and Samsung can do the same but they are hamstrung by their high stock prices and the market’s expectation that they will maintain strong margins. Nokia has no such “problem” since its stock and margins are now distressed. Low expectations can sometimes be an advantage. (The same applies to other players who have fallen behind and have little to lose.)

To be sure, there are already lower priced or even free iOS and Android phones sold by the US carriers. For example, AT&T sells the 8GB iPhone 4 for 99 cents + an activation fee of $36 and a two-year contract. But a $99 price for an Asha-like phone, pre-subsidy or without contract, would still be significantly cheaper. AT&T sells the iPhone 4 without contract for $450.99.

In recent years, the key success factors in the smartphone business were product and technology. As prices tumble and consumers’ appetite for more functions start to fade, the new success factors will be price, manufacturing and logistics, all factors at which Nokia has excelled in the past. Perhaps it can do it again. If it does not, someone else will.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Nokia stock or any other security. The reader is responsible for any loss he may incur in such trading.