Saturday, June 19, 2010

Population fall poses immense new challenges

Peter Costello used to say demography is destiny. Like many of the things he said, that's an exaggeration. But it is going to have a big effect on your future.

Demography is the study of human populations. In principle, it's quite separate from economics. But economists are likely to be saying a lot more about it - and boning up on it - because demographic change will have a big effect on the thing they care about most: the growth of the economy.

Actually, as you realise when you read the article by Jamie Hall and Andrew Stone in this quarter's Reserve Bank Bulletin, demographic change has always had a big effect on the growth in gross domestic product.

It's just that, because so far its effect on growth has been positive, we've been able to take it for granted. From about now, however, its effect is likely to be negative, so we'll be taking a lot more notice.

Leaving aside migration (as we will do in this article), the main factor that drives population growth is the fertility rate - the number of babies per woman. (The death rate also matters, obviously, but we'll also take rising longevity as read.)

The world's population has been growing rapidly for most of the past century, thanks to improvements in public health, medical science and economic development. But the global fertility rate has been falling sharply since the end of the postwar baby boom. From five babies per woman it's now down to about 2, thanks to the spread of effective contraception and rising living standards.

United Nations projections foresee the rate falling to two babies per woman by the middle of this century, which is lower than the replacement rate of 2.1 babies.

So the rate of growth in the world's population has been slowing for decades and, while population is expected to continue growing until the second half of this century, it will then start to decline.

Get that: some of our youngsters will live to see the world's population falling. But population decline will start earlier in some countries than others. Indeed, it's already started in Japan and Germany. And it won't be just the rich countries where population is falling.

The growth in a country's output of goods and services (GDP) can be viewed as coming from two sources: growth in the input of labour and improvement in the productivity of that labour. Three main factors determine the growth in the input of labour: growth in the population, growth in the proportion of the population that is of working age, and changes in the rate at which people of working age choose to participate in the labour force. (Again for simplicity we'll ignore changes in the participation rate.)

Over the 10 years to 2005 the United States' average growth in real GDP was 3.3 per cent a year. Turns out that 1.1 percentage points of that growth came from increased population (meaning it did nothing to raise America's standard of living) and 0.2 percentage points came from the rising proportion of the population that was of working age (here assumed to be those aged between 15 and 64).

But now Hall and Stone estimate that, over the 10 years to 2020, the average annual contribution to economic growth from population increase will be a smaller 0.9 percentage points, and the contribution from change in the working-age share will be minus 0.3 percentage points.

In other words, America's average rate of economic growth is expected to be 0.8 percentage points a year (or about a quarter) less, simply because of direct demographic change. The equivalent expected declines in the demographic contribution are 0.6 percentage points for Japan, 0.3 points for Germany and 0.2 points for Italy.

Why is America's loss likely to be greatest? Because demographic change is only now catching up with it. The others have already taken a fair bit of their medicine. It turns out that most of Japan's "lost decade" of weak economic growth is explained by its ageing and now declining population. Without that, its growth was much the same as Germany's.

So far we've tended to think of slow-growing or falling population as an issue purely for the developed countries. But Hall and Stone demonstrate that the coming decade will see demographic change making a reduced contribution to growth throughout Asia.

What's more, China's population will start to fall slowly in about 20 years' time and South Korea's population will peak in 10 year's time and then fall quite rapidly.

Looking again at the 10 years to 2005, China's economic growth averaged 8.8 per cent a year. Of this, 0.8 percentage points came from population increase and 0.6 percentage points from a higher working-age share.

Over the coming 10 years, however, Hall and Stone estimate that population's contribution to growth will slow to 0.6 points a year and the working-age share's contribution will be minus 0.3 per cent. So demography's contribution to growth will be 1.2 points a year lower than in the previous period.

Now take Korea. Demography contributed 0.7 percentage points to its average economic growth of 4.4 per cent a year in the first period, but will make a zero contribution over the coming decade.

The general story for east Asia (the five main ASEAN countries plus Korea, Taiwan and Hong Kong, but excluding China and Japan) is that demography's contribution of 1.8 percentage points (or almost half) during the 10 years to 2005 will fall to 1 percentage point in the coming decade.

But two Asian countries stand out from this general picture of demographic change making a significantly reduced contribution to economic growth over the next 10 years. Population growth in Indonesia and India will be slowing, but still relatively strong.

So the demographic contribution in Indonesia will slow only from 1.9 percentage points a year to 1.2 points a year. In India it will slow only from 2.2 points a year to 1.6 points.

Much of the demographic difference between China on one hand and India and Indonesia on the other would be explained by differences in population control policies, particularly China's one-child policy, which is about to really make its presence felt. (The main explanation for Korea, I suspect, is simply rising affluence prompting people to have fewer kids.)

But however it's explained, the likelihood is that, in about 2030, India will overtake China as the most populous country. So rest assured, economists will be saying a lot more about demography in coming years.