Friday, January 23, 2015

Intertemporal Discount Rate and Demographic Collapse

For a change of pace, read a mildly interesting article in "El Pais" (originally a Spanish newspaper, but for the last two decades the propaganda organ of certain branch of the Country's main Socialist Party) about the impact of an aging population in the Intertemporal Rate of Discount (Taxes Against Deflation). The conclusion was that relatively small increases in the percentage of old people in a society can significantly depress the aggregate discount rate (as geezers supposedly have a smaller preference for present over future consumption compared with youngers, even preferring money in the future to money now, which translates to a negative IRD), which can in turn be understood from two vantage points: from the side of the lenders, it lessens the average of what the society asks for in exchange for renouncing present consumption (freeing the money for investment); but from the side of the borrowers it is ready to lend them money asking for less in return. The IRD is a theoretical construct, its relevance being that the average rate the banks charge their customers (and pay their depositors), as well as the average rate the state pays for financing itself, tend to gravitate towards that value. And those rates in turn have been (more markedly in the Keynesian tradition) one of the main tools of the rulers (through their central banks, which are universally in charge of setting monetary policy and have more influence than any other institution in setting those rates... except if you enter in a monetary union and relinquish the control of such a tool, which, in light of developments over the last four years, doesn't necessarily seem as the wisest thing to do, but I digress).

Normally high interest rates (consistent with a high IRD) are seen as a bad thing: people is so fearful or so uncertain about the future that they ask for a lot of additional money in order to accept to forgo present consumption. That high price of money drives it away from investments, so the economy does not grow as much as it could. But ironically, the fact that even at those high rates the market clears means that there are people (or institutions) willing to run the risk and part with their cash at that price, even knowing that their expectations may be thwarted and they may never recover that cash. Behind every loan there is a potential disillusion, from the borrower, that believed that his lot would improve and he would be able to pay back (with the corresponding interest) and from the lender, which expected to recover the principal after receiving the interests. What both lender and borrower have to share for the money to change hands is the common belief that the economic fortunes of the latter are going to improve. The more uncertainty there is about the likelihood of such improvement, the more reluctant would the creditor be, and the more reward he would ask for running the risk. That is why typically central banks would only rise rates (with the expected effect of "cooling" the economy, making it grow less to the point, as Paul Volcker famously did at the beginning of the Reagan years, of causing a depression and actually shrinking it) to avoid what is considered a worse situation, which is the existence of persistent high inflation. Now what gets tricky is that inflation affects in turn the IRD, as if people expect the overall price level to go up they will be more than willing to part with their money as soon as possible, as it becomes less valuable with every passing day, and will ask a much higher price to agree to dispose of it at a later time, to compensate for its loss of value, driving the rates further up.

So you would think that the effect I mentioned of depressing IRD by having more old people that intrinsically tend to prefer to consume later would be a blessing, as they blunt the effect of inflation on rates, right? wrong. It happens that, as having too high rates is bad for society (makes most investments unattractive in comparison, and those that stay attractive are usually wildly risky and thus unpredictable), having too low rates is no walk in the park, and in the current historical moment those low rates seem likely to become a fixed feature of the landscape, as we are in the precise instant in the development of the Western civilization at which economy catches up with demography....

Let's see first why and when a low IRD may be bad. Basically, the problem with rates of return of money is that they have a lower bound of zero. You don't want to have to pay to spend money, as that means that everybody expects it to gain value with time just by holding onto it (i.e. a deflationary scenario, something that in practice has been exceedingly rare in our economic history, except for the last three decades in Japan, and most likely in Europe right now). Now if your money will allow you to buy more goods with it next month, why on earth would you spend it today (except to satisfy your most basic, non-delayable needs)? of course you wouldn't, and the effect of everybody delaying their purchases is a contracting economy, idle capacity, increasing unemployment (who would manufacture goods that will have great difficulty finding buyers?) and overall despair.Although a very-low-rate scenario sounds like a great time to go into debt (it is cheap to get that money to spend today above your current income and pay a pittance for it down the road), it actually isn't, as a deflationary scenario continuously increases the real value (in goods) of the amount that has to be repaid. If we link the intertemporal rate of discount with the economic prospects of society as a whole, we can say that a high IRD is the consequence of a society that thinks its economy is going to grow, that incomes overall are going to increase, so debts will on average be less burdensome and most will finally be repaid, that valuable opportunities for investment abound, and thus that money should command a high reward, as it will be worth less in the future. On the other hand side, a low IRD befits a society that has lost faith in the inevitability of growth, that assumes that incomes will be stagnant or even decrease, that debts will be as burdensome to pay a year hence (or a decade hence) as they are today, that opportunities for investment are few and far away, so money (even the current supply, no need of authorities printing more of it) will be abundant, but not so much as unsold goods, and thus will increase in value.

Now of course material output could not keep on growing at the breakneck speed it has been growing since the XVIII Century, so at some point in time we would have to transition to something closer to the "steady state" envisioned by Stuart Mill. Of the two variables that drive the growth of that material output (population growth -there is more people to produce thingies- and productivity growth -each individual person can produce more) we know the first one (population) petered out in the West about four decades ago. Now we have been witnessing that the second, whose main engine is technological advance, is also petering out (as I expounded in this post: )Decrease in the rate of technological progress). And most likely that second deceleration is a consequence of the first (older people tend to innovate less than young ones). So we better get used to a scenario of permanent deflation (see the failure of Japan's growingly desperate attempts to escape their deflationary trap, after more than tripling the balance sheet of the BoJ -the closer thing we have witnessed of a government showering the population with money from helicopters, and still no increase in prices, or in aggregate demand for that matter), and of low interest rates (which probably will not preclude a tiny sliver of the population to grow increasingly much more richer than the rest, as even that meager return is likely to outstrip even more anemic inflation, as per Piketty).

What we have to turn our attention to, then, is why we have collectively decided to commit demographic suicide, as the economic scenario is the unavoidable consequence of the population collapse which is just starting to unfold. But this post has grown already too long, so we will leave the answer for a following one...

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