The Murder-Suicide of the Rentier: Population Aging and the Risk Premium

April 20, 2020

By Joseph Kopecky and Alan Taylor

Population aging has been linked to global declines in interest rates. A similar trend shows that equity risk premia are on the rise. An existing literature can explain part of the decline in the trend in safe rates using demographics, but has no mechanism to speak to trends in relative asset prices. We calibrate a heterogeneous agent life-cycle model with equity markets, showing that this demographic channel can simultaneously account for both the majority of a downward trend in the risk free rate, while also increasing premium attached to risky assets. This is because the life cycle savings dynamics that have been well documented exert less pressure on risky assets as older households shift away from risk. Under reasonable calibrations we find declines in the safe rate that are considerably larger than most existing estimates between the years 1990 and 2017. We are also able to account for most of the rise in the equity risk premium. Projecting forward to 2050 we show that persistent demographic forces will continue push the risk free rate further into negative territory, while the equity risk premium remains elevated.

To continue on the theme mentioned here two weeks ago, population aging is crucial for some many economic outcomes. This paper adds to it. However, I am starting to wonder whether the current pandemic is going to make those changes less drastic as it will lead to less pronounced aging of the population.

Females, the elderly, and also males: Demographic aging and macroeconomy in Japan

July 7, 2019

By Sagiri Kitao, Minamo Mikoshiba and Hikaru Takeuchi

The speed and magnitude of ongoing demographic aging in Japan are unprecedented. A rapid decline in the labor force and a rising fiscal burden to finance social security expenditures could hamper growth over a prolonged period. We build a dynamic general equilibrium model populated by overlapping generations of males and females who differ in employment type and labor productivity as well as life expectancy. We study how changes in the labor market over the coming decades will affect the transition path of the economy and fiscal situation of Japan. We find that a rise in the labor supply of females and the elderly of both genders in an extensive margin and in labor productivity can significantly mitigate effects of demographic aging on the macroeconomy and reduce fiscal pressures, despite a decline in wage during the transition. We also quantify effects of alternative demographic scenarios and fiscal policies. The study suggests that a combination of policies that remove obstacles hindering labor supply and that enhance a more efficient allocation of male and female workers of all age groups will be critical to keeping government deficit under control and raising income across the nation.

Japan should be more studied because it is a real-life laboratory of what is going to happen to other industrialized economies. First, it experienced from the 1990s a long period of very low interest rates, which other countries got to experience in the last ten years. Second, it is right now going through a very significant ageing transition of its population, which will soon happen as the Boomers retire in Western Europe and North America. This paper shows what to expect, in particular some endogenous responses of the labor force that we typically assume out of our models.

Firm and Worker Dynamics in an Aging Labor Market

May 10, 2019

By Niklas Engbom

I develop an idea flows theory of firm and worker dynamics in order to assess the consequences of population aging. Older people are less likely to attempt entrepreneurship and switch employers because they have found better jobs. Consequently, aging reduces entry and worker mobility through a composition effect. In equilibrium, the lower entry rate implies fewer new, better job opportunities for workers, while the better matched labor market dissuades job creation and entry. Aging accounts for a large share of substantial declines in firm and worker dynamics since the 1980s, primarily due to equilibrium forces. Cross-state evidence supports these predictions.

In retrospect, the central idea of the paper makes a lot of sense. Does the aging of the population do any good?

The Costs and Benefits of Caring: Aggregate Burdens of an Aging Population

September 28, 2018

By Finn Kydland and Nicholas Pretnar

There has been recent attention to the increasing costs to individuals and families associated with caring for people who are afflicted with diseases such as dementia, including Alzheimer’s. In this paper we ask, what are the quantitative implications of these trends for important aggregates, including going forward in time. We develop an overlapping generations general equilibrium model that features government social insurance, idiosyncratic old-age health risk, and transfers of time on a market of informal hospice care from young agents to old agents. The model implies that the decline in annual output growth in the United States since the 1950s can be partly attributed to decreases in the working-age share of the adult population. When accounting for the time young people spend caring for sick elders, positive Social Security + Medicare taxes lead to reductions in the growth rate of annual output of approximately 20 basis points. Relative to an economy with no old-age insurance systems, Social Security + Medicare taxes lead to future reductions in output of 6% by 2056 and 17% by 2096. We show that depending on the working-age share of the adult population, eliminating Social Security + Medicare is not necessarily Pareto improving, leaving those afflicted by welfare-reducing diseases worse off. Placed in the context of an aging United States population, these phenomena could have dramatic or muted impacts on future economic outcomes depending on the prevalence rate of high-cost diseases and the rate at which labor is taxed to fund old-age consumption under a pay-as-you-go social insurance system.

This paper addresses a potentially important, yet neglected issue about aging: the additional burden of the various forms of dementia, which seem to become more prevalent. Depending how this condition and its treatment and prevention evolve, the impact could be dramatic.

Policy Uncertainty and the Cost of Delaying Reform: A case of aging Japan

February 25, 2016

By Sagiri Kitao

In an economy with aging demographics and a generous pay-as-you-go social security system established decades ago, reform to reduce benefits is inevitable unless there is a major increase in taxes. Often times, however, there is uncertainty about the timing and structure of reform. This paper explicitly models policy uncertainty associated with a social security system in an aging economy and quantifies economic and welfare effects of uncertainty as well as costs of delaying reform. Using the case of Japan, which faces the severest demographic and fiscal challenges, we show that uncertainty can significantly affect economic activities and welfare. Delaying reform or reducing its scope involves a sizeable welfare tradeoff across generations, in which middle to old-aged individuals gain the most at the cost of young and future generations.

Much has been written how policy uncertainty can have an impact of the economy, including on this blog. But as far as I can see, this uncertainty was pertaining to fiscal or monetary policy. The uncertainty this paper addresses, social security reform, is an order of magnitude more important because it implies bigger policy shifts that are perceived as permanent and have potential large impact on many people, in particular regarding labor supply decisions. And the uncertainty is potential larger, too, as policy makers tend to put off such politically dangerous reforms for many years.

Declining Trends in the Real Interest Rate and Inflation: Role of aging

January 13, 2016

By Shigeru Fujita and Ippei Fujiwara

This paper explores a causal link between the aging of the labor force and declining trends in the real interest rate and inflation in Japan. We develop a new Keynesian search/matching model that features heterogeneities in age and firm-specific skill levels. Using the model, we examine the long-run implications of the sharp drop in labor force entry in the 1970s. We show that the changes in the demographic structure driven by the drop induce significant low-frequency movements in per-capita consumption growth and the real interest rate. They also lead to similar movements in the inflation rate when the monetary policy rule follows the standard Taylor rule, failing to recognize the time-varying nature of the natural rate of interest. The model suggests that the aging of the labor force accounts for roughly 40% of the decline in the real interest rate observed between the 1980s and 2000s in Japan.

Are interest rates, currently at record low levels in many countries, ever going to go back to “normal” levels? This depends not only on central bank policy but also on the level of the natural real interest rate. And there is no reason to believe that the latter should be constant. This paper shows that population aging can have a substantial impact on the natural real interest rate. Japan is used as an example because it is the first population to age substantially, and other industrialized economies have started to go through that process as well. There are thus likely to see a decrease in the natural real interest rate.

Household leveraging and deleveraging

March 24, 2013

By Alejandro Justiniano, Giorgio Primiceri and Andrea Tambalotti

U.S. households’ debt skyrocketed between 2000 and 2007, but has since been falling. This leveraging and deleveraging cycle cannot be accounted for by the liberalization and subsequent tightening of mortgage credit standards that occurred during the period. We base this conclusion on a quantitative dynamic general equilibrium model calibrated using macroeconomic aggregates and microeconomic data from the Survey of Consumer Finances. From the perspective of the model, the credit cycle is more likely due to factors that impacted house prices more directly, thus affecting the availability of credit through a collateral channel. In either case, the macroeconomic consequences of leveraging and deleveraging are relatively minor because the responses of borrowers and lenders roughly wash out in the aggregate.

What I take from this paper is that changes in credit standards and thus lenders cannot be blamed. Anything that would have increased house prices “excessively” is still a potential culprit, including herd behavior, too low interest rates, excessive expectations, or a bubble.

Monetary Policy over the Lifecycle

September 23, 2021

By Anton Braun and Daisuke Ikeda

A tighter monetary policy is generally associated with higher real interest rates on deposits and loans, weaker performance of equities and real estate, and slower growth in employment and wages. How does a household’s exposure to monetary policy vary with its age? The size and composition of both household income and asset portfolios exhibit large variation over the lifecycle in Japanese data. We formulate an overlapping generations model that reproduces these observations and use it to analyze how household responses to monetary policy shocks vary over the lifecycle. Both the signs and the magnitudes of the responses of a household’s net worth, disposable income and consumption depend on its age.

I wonder whether these results carry over for an aging economy, especially as there may be general equilibrium effects that may amplify or reduce the implications.

Time Preferences over the Life Cycle and Household Saving Puzzles

March 29, 2021

By Wataru Kureishi; Hannah Paule-Paludkiewicz; Hitoshi Tsujiyama; Midori Wakabayashi

Most economic models assume that time preferences are stable over time, but the evidence on their long-term stability is lacking. We study whether and how time preferences change over the life cycle, exploiting representative long-term panel data. We provide new evidence that discount rates decrease with age and the decline is remarkably linear over the life cycle. Decreasing discounting helps a canonical life-cycle model to explain the household saving puzzles of undersaving when young and oversaving after retirement. Relative to the model with constant discounting, the model’s fit to consumption and asset data profiles improves by 40% and 30%, respectively.

If one thinks that discounting has to do with survival probabilities, one is sorely mistaken, apparently. Note that a discount rate that declines over a life time is consistent with aging economies having lower interest rates. The implications from the paper are interesting.

Rare disasters, the natural interest rate and monetary policy

January 13, 2021

By Alessandro Cantelmo

This paper evaluates the impact of rare disasters on the natural interest rate and macroeconomic conditions by simulating a nonlinear New-Keynesian model. The model is calibrated using data on natural disasters in OECD countries. From an ex-ante perspective, disaster risk behaves as a negative demand shock and lowers the natural rate and inflation, even if disasters hit only the supply side of the economy. These effects become larger and nonlinear if extreme natural disasters become more frequent, a scenario compatible with climate change projections. From an ex-post perspective, a disaster realization leads to temporarily higher natural rate and inflation if supply-side effects prevail. If agents’ risk aversion increases temporarily, disasters may generate larger demand effects and lead to a lower natural rate and inflation. If supply-side effects dominate, the central bank could mitigate output losses at the cost of temporarily higher inflation in the short run. Conversely, under strict inflation targeting, inflation is stabilized at the cost of larger output losses.

I mentioned several times on this blog that demographic aging is a source of declining interest rates. Now add climate change to the mix. As it looks like declining fertility may also come from climate change, the two shocks may reinforce each other in reducing interest rates. After a decade or two with interest rates kept low by policy, they may not be increasing that much once we get back to “normal” times.