Demographic Effects

Last week financial press had two interesting articles about economic effects of declining populations. FT mentioned a paper by Masaaki Shirakawa, former governor of BoJ, where he claims that decline in a country’s working age population leads to deflation. Older people spend less than the young, and take less debt. As a result, domestic demand falls and deflationary pressures build. This is where the second article picks up. A research paper quoted in Reuters claimed that monetary policy becomes less effective as societies age. Older people save more, borrow less and therefore are less sensitive to interest rate changes than the young. Therefore, as societies age, central banks have to pull harder to achieve the same end results.

Central banks in ageing western (and some Asian) countries are already doing that. Policy rates are at historic low and for historic long. QE, a different version of the same concept of cheaper debt, also has no end in sight. The effect is higher investment flows leading to asset price inflation, and potentially a bubble somewhere. That somewhere may well be developing markets. Huge amount of hot money inflow is having destabilizing effect in these countries. Asset price inflation with possible asset bubble is one such effect. Higher interest rate volatility and market uncertainty are others.

The second observation of fall in domestic demand in ageing countries also suggests that these economies may need to be rebalanced away from credit fueled domestic consumption. Then, fiscal policies become more important for economic growth. Also, deflation may only be a mechanism to shrink industry down to demand level. Then, central banks might want to rethink their stance of fighting deflation by all means. Net conclusion – rethink current monetary policies.  

Greece endgame

Crisis in Europe is like Duracell, it goes on and on. In Greece, the government keeps agreeing to increasingly harsher austerity demands of European creditors, apparently with no clear plans of how to implement them.

Implementation – is going to be very difficult. People will not go through the resulting pain quietly. Firstly, nobody likes austerity if it affects them. And secondly, if they still have to bear it, three conditions should be met. - a) People should feel it is justified (decision makers should be credible), b) it is temporary (lasts for a short time), c) and it will end in a beneficial situation for them. In the present case, austerity measures are obviously being driven by foreigners. Greece has already gone through 4 years of recession, has 50% youth unemployment, and no improvement in economy to show for it. Greek citizens will therefore, find it difficult to accept current austerity measures. Therefore, Greece will continue to witness strong social unrest (Athens is already burning).

These conditions make it very difficult for any democratic government to implement more austerity, especially in crunched time. Ultimately, Greek government will fail to meet these targets and default on its payments. This will likely be followed by Greece exiting Eurozone – voluntarily or involuntarily. 

Risks to Greece from a default are already known. New Drachma will be a severely depreciated currency resulting in high import inflation. Greece won’t have access to credit for some period of time and the economy would still be in need of reforms. However, an exit from Eurozone may also mark the bottom for its economy. The default will remove uncertainties in the market about the event. Economic reforms from here on will be internally driven and thus would have more credibility and less domestic opposition. A depreciated currency may also help export growth. Thus, any stabilization or improvement in economy should also increase value of New Drachma rapidly, and with it, value of any investment made in this currency.