Tilting The Scales Demographics & The Cost of Capital



A fertility rate of 2.1 per woman is the minimum needed to stabilize a society’s population. Anything below that will cause the population to decline within a generation. Europe is at 1.55, Japan is at 1.3, and most of the important countries of Europe are around 1.3. Germany, Italy, and Russia are at the bottom of the heap. Even China is at 1.6. More importantly, there is no historical precedent for a country to increase a declining birth rate, except through immigration. The US is doing that, raising its birth rate for white Caucasians from 1.9 to a national Birth Rate of 2.1, just enough to maintain the population. The difference is made up by the higher fertility of African- Americans and Hispanics.

Declaimer: This article written was originally in March 2015, and some of the data points may be outdated.

Why does this happen?

Why does this happen? In low-income societies, children are seen as an earning asset and a support system in old age. In developed societies, children are a drain on parental resources, and increasingly, not much of a support in old age. We have seen this spectacularly in urban India, which has moved from the joint family system to nuclear and even individual family units in a single generation. There is a direct correlation between urbanization, per capita GDP, and a drop in fertility rates.

Throughout my generation, we have rued a high population growth and celebrated low (population) growth rates. But the deflation/ depression that pervades societies in long-term demographic decline, is visible in Japan for the last 25 years and is now being anticipated in almost the entire developed world. It creates an ‘inverted pyramid’, where a small number of workers have to support a large number of dependents. This increasing Dependence Ratio creates stresses in society, especially when the debt (and social obligations) of earlier generations has to be paid off. That is why the current deflation/ depression scenario could prove to be especially burdensome for the coming generation.

At an individual (country) level, immigration and productivity growth could mitigate the effect of the debt hangover. Japan has seen very high productivity growth in a deflationary economy, which is why at an individual level, we have not seen the kind of misery that one would expect, say, in a Depression. Per capita GDP has stayed buoyant, in a zero-inflation economy, leading to better living standards despite a high Dependence Ratio. High savings and a persistent Current Account surplus have ensured that their household sector remains a creditor nation. Perversely, the new Abeonomics philosophy to print money and service debt will eventually lead to inflation, but if it happens after the aging 65+ segment has been seen off, there will be much less misery than had they taken any other course. Once the “geriatric hump” has been seen off, a sharp inflationary shock that demonetizes the Yen and reissues a new currency would settle the bankruptcy problem once and for all. It has been done before (in Germany in 1920); in a country with a low Dependency Ratio, wages will catch up with inflation, provided productivity remains buoyant.

The difference between Higher Productivity and a higher stock of capital

Higher productivity produces a higher stock of capital, especially over a longer period. As the population drops and debt gets paid off, a society gets richer in real terms, not poorer. Throughout history, the population has been rising and so has debt, resulting in lower equity per person (a.k.a. wealth). Now, as the equation reverses, a dropping absolute number of people with a rising cumulative stock of capital (i.e. wealth) will result in higher equity per person. This will reduce leverage ratios and lead to higher consumption, which is a must if all that higher productivity is to find an outlet. For the first time in history, higher wealth will come with a falling population. That will make labor more scarce than capital, and I don’t know how society will handle that. Certainly, the elitist mindsets that wear the suits in finance and industry today would be caught unprepared, I am sure. Politicians, also, will be blindsided. All this will take a good half-century to play out but will be seen at different stages in different societies. India will have time to learn from others because it will be the last to enter this stage.

There are 2 jokers in this pack: one, productivity rises so fast that it renders labor surplus faster than the population can reduce. The magic number is 2.5% because the decline in most country populations will be about 1% in the worst of cases. This does not look impossible, given the twin booms in energy and robotic automation that seem to be around the corner. Two, they find breakthroughs in cloning or some method of asexual reproduction, which allows specific countries or ethnic groups to reverse their declining demography. At the moment, Japan and Germany certainly look like they would do something drastic to arrest their demographic decline.

Of the four inputs to production: land, labor, organization, and capital, only 2 would be left valuable. In a zero-cost energy society, also facing a declining population, the real cost of land would drop to nothing. We can see that spectacularly in Japan, where real estate is still 80% below 1989 levels. That should be a lesson to those readers who look at real estate as the most durable legacy they want to leave behind for the next generation.

Organisation is just a higher form of labour, which in a falling population, would tip the scales in its favor, vis-a-vis capital. This would increase per capita GDP. Intelligent readers can draw some serious long-term direction from this if they want to finish planning their children’s careers. If I know crowds well, most people will be caught in the middle of a real estate crisis before they start to question the existing wisdom of “real estate being the safest investment”. Bond market bears who are perpetually betting on a sharp rise in Interest Rates may find themselves waiting for Godot.

That brings us to our conclusion

That brings us to our conclusion. With demographic decline, you get a falling cost of Capital, as opposed to the cost of Labour. That reduces the opportunity cost for investors, even as it reduces corporate profitability because of wage inflation. So countries in demographic decline, which includes Japan, most of Europe, and even China, are going to see this scenario. These countries will also see rising wealth and savings, even as they see falling investment opportunities. This is already visible in some countries and will become visible in others (e.g. China).

Countries that are laggards in this (demographic) trend, like the US and of course, India, will have a higher cost of capital and lower wage costs. They will see better investment opportunities and of course, will be net capital importers. From a currency standpoint, it makes sense to “carry trade” from the poor demography countries and invest in the better demographies. We know that Carry Trades work, but only over the long term. This would be particularly true over periods of sharp demographic change, like the ones we are going to see over the next 15 years.

For Indian investors, who are heavily loaded up with real estate, the path forward is clear. A worldwide drop in the cost of capital will see disinflationary trends drop the cost of capital, although we will not step into deflation. This will reduce returns from real estate. They would do well to borrow in currencies that are facing demographic decline and find pockets in the Indian markets, where you get healthy differential returns. The actual methods may look a little complex, because they may have many legs, but the underlying philosophy is recounted above. Remember one very important principle of investing: go where you can see predictability. Any investment hypothesis that is based on something as unchangeable as demographics, has to be very robust. And this single hypothesis could help you generate outsize returns for a very long time.

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