Bull's Eye Investing: Demography Is Destiny

John Mauldin, in an excerpt from his book Bull’s Eye Investing, outlines the retirement problems the world faces.

There is no free lunch.
-Milton Friedman

NOW, LET’S LOOK away from the United States, and focus on the rest of the world. If we think the retirement problems facing the United States are severe, then the facts suggest the rest of the developed world is facing a major crisis. Over the next few decades, we are going to see a shift in economic and political power that is simply staggering in its implications. Let’s look at facts first, and then draw conclusions.

I am going to quote at length from a study by the respected Bank Credit Analyst. Martin Barnes and his crew at BCA Research have a stellar reputation for having been as accurate as any letter in the world for decades. They give us some sobering thoughts.

The populations of the developed countries will drop rapidly over the next 50 years, while those of undeveloped countries, especially Islamic countries, will rise dramatically. (See Figure 11.1, Figure 11.2, and Table 11.1.) Germany will experience no population growth and will remain at 80 million people, while Yemen will grow from 18 million to over 84 million.

Russia will drop from 145 million to slightly over 100 million. Iran will grow from 66 million to 105 million. Japan will drop to 109 million, while Iraq and Saudi Arabia will grow to 110 million each. Italy will decline from 57 million to 45 million, while Afghanistan will grow from 21 million to 70 million.

This underscores the 100-page CIA report released in July 2001, entitled Long-Term Global Demographic Trends: Reshaping the Geopolitical Landscape. To quote from that report:
Dramatic population declines have created power vacuums that new ethnic groups exploit. Differential population growth rates between neighbors have historically altered conventional balances of power. . . .Our allies in the industrialized world will face an unprecedented challenge of aging. Both Europe and Japan stand to lose global power and influence. . . . The failure to adequately integrate large youth populations in the Middle East and sub-Saharan Africa is likely to perpetuate the cycle of political instability, ethnic wars, revolutions, and antiregime activities that already affect many of these countries. Unemployed youth provide exceptional fodder for radical movements and terrorist organizations, particularly in the Middle East.
Bull’s Eye Investing: BCA Conclusions
The Canadian-based BCA concludes:
The cynical view is that the U.S. desire to attack Iraq is mainly about oil. That may be part of the agenda, but other long-term strategic considerations are probably at work. The growing number of young people in a number of unstable or troubled countries could work both ways. For example, there are signs that many young people in Iran want the country to move away from fundamentalism toward a more relaxed regime. The rising power of youth can be a force for positive change as opposed to instability. However, there will be a huge challenge in bringing democracy to countries that have no history of it. This will be especially true if the global economy is struggling because poor demographics are undermining demand in the industrialized world. (Emphasis mine)

Let’s look at some of BCA’s other conclusions:

Declining aggregate demand in the developed world. Sharp declines in working-age populations in Europe and Japan will lead to large falls in the demand for consumer goods and real estate. Demand for aging-related services will rise, but not by enough to offset the growth-sapping impact of falling demand in the prime income-earning age group.

Full employment and labor shortages in the industrialized economies. There will not be any problem finding jobs, and a negligible unemployment rate implies that real wages should tend to rise. This will be good for per capita incomes, but not for profit margins.

Steady demand growth in emerging countries. Rising populations hold out the hope that demand growth in many parts of the developing world will offset the weakness in industrialized countries. However, there will be huge regional differences within the emerging markets, with Asia likely to be the star performer, and Africa remaining mired in crisis.

Continued transfer of manufacturing production to Asia. The shift in manufacturing capacity to Asia will continue, not least because of weak demand and labor shortages in the developed world. Even the auto industry may eventually move away from Europe and the United States. The developed economies will thus continue to become increasingly service oriented.

The welfare state will be under threat. It will be difficult to maintain the current level of public sector services and transfer payments as fiscal strains rise. It is almost inevitable that the retirement age will rise in most advanced economies and real benefits may be cut. Meanwhile, aging populations will put immense pressure on state-funded health care facilities. New medical technologies could even exacerbate the problems by creating expensive new treatments and boosting life expectancy rates.

It may be difficult to keep the euro area intact. Europe’s grim fiscal outlook raises a big question mark about the sustainability of the euro zone. The Stability and Growth pact will eventually have to be scrapped, and different fiscal positions across countries will create enormous strains, given a common monetary policy and currency. Meanwhile, expanding the European Union eastward will not alleviate Europe’s demographic problems as all the new prospective members (Turkey excepted) have even weaker population dynamics than existing EU members.

China will face many of the same problems as the West. The Chinese economy currently is booming, but it too faces demographic challenges down the road. The fertility rate is below replacement level and the working-age population is projected to peak in around 2025. This will make it easier to employ those workers flowing from rural areas to cities, but, as in other countries, the aging population will create a large fiscal problem, albeit later than in the West. Other important issues discussed in the CIA report include the implications of increased urbanization in a number of unstable countries, the global spread of infectious diseases, and the adverse environmental consequence of rapid population growth in the developing world.

The long-run picture for Europe and Japan looks bleak in that a deteriorating fiscal picture will be bearish for bonds while weak aggregate demand is bearish for stocks. Those two trends would be consistent if the eventual outcome is a stagflationary environment, which could occur in the context of labor shortages and attempts to inflate out of a government debt trap. (Emphasis mine)

Bull’s Eye Investing: Age Vulnerability: Your Pension or Your Life
Let’s next look at a lengthy report entitled “The 2003 Aging Vulnerability Index by Neil Howe and Richard Jackson. (Howe was co-author of the Seminal books on generational behavior trends, Generations and The Fourth Turning.)
The report analyzes the cost of public pension funds (like Social Security, the state retirement funds mentioned earlier, etc.) for 12 different developed countries. It then analyzes how the various countries will fare in the future, factoring in their economies, taxes, costs, and the actual circumstances surrounding retirement. (For instance, it makes a difference whether you are likely to be supported by your kids or out on your own.)

In short, it clearly shows us that there will be staggering budget problems for these countries, and some more than others. The report categorizes Australia, the United Kingdom, and the United States as low vulnerability countries. (See Table 11.2.) Given what we know of potential U.S. problems from an aging population, this means the report posits grim news for certain countries, especially the mainstay countries in Europe (France, Germany, Italy, Spain, and the Netherlands). Jackson and Howe give a whole new meaning to the concept of “Old Europe.”

Bull’s Eye Investing: As Many Retirees as Workers

Let’s look at a few salient items:

Today, there are 30 pension-eligible elders in the developed world for every 100 working age adults. By the year 2040, there will be 70. In Italy, Japan, and Spain, the fastest-aging countries, there will be 100. In other words, there will be as many retirees as workers. This rising old-age dependency ratio will translate into sharply rising costs for pay-as-you-go retirement programs-and a heavy burden on the budget, on the economy, and on working age adults in any country that does not take serious steps to prepare. . . . Public benefits to the elderly will reach an average of 25 percent of GDP in the developed countries by 2040, double today’s level.

. . . In Japan, they will reach 27 percent of GDP; in France, they will reach 29 percent; and in Italy and Spain, they will exceed 30 percent. This growth will throw into question the sustainability of today’s retirement systems-and indeed, society’s very ability to provide a decent standard of living for the old without overburdening the young. . . . It is unclear whether they can change course without economic and social turmoil. (Emphasis mine)

For most of history, the elderly-here defined as adults aged 60 and over-comprised only a tiny fraction of the population, never more than 5 percent in any country. Today in the developed countries, they comprise 20 percent. [See Figure 11.3.] Forty years from now, the share will reach roughly 35 percent. And that’s just the average. In Japan and some of the fast-aging countries of continental Europe, where the median age is expected to exceed 50, the share will be approaching 50 percent.

Today, looking at the data, the five main economies of the European Union spend about 15 percent of their GDP on public benefits to the elderly. This will rise rapidly to almost 30 percent by 2040. Japanese benefits will rise 250 percent to 27 percent in 2040 from today’s “mere” 11.8 percent. How do you pay for such increases? If the increase were paid for entirely by tax hikes, not one European country would pay less than 50 percent of its GDP in taxes, and France would be at 62 percent. By comparison, the U.S. tax share of GDP would rise from 33 percent to 44 percent (according to the report; I assume this includes all level of taxes). Japan’s taxes would be 46 percent of GDP.

It should be clear to everyone that such an outcome would be an utter economic disaster. Taxes for the working population would be consuming 80 to 90 percent of their income. It would be an economic death spiral. Whatever economic growth might be possible in an aging United States, Europe, or Japan would be completely squelched by such high taxes. The “giant whooshing sound” would be that of young workers leaving for more favorable working and tax conditions.

If the increase in benefit costs were paid for entirely in cuts to other spending projects, Japan would see its public benefits rise to 66 percent of total public spending, France and the United States to 53 percent, and Germany to 49 percent. Today, these expenditures are all around 31 percent. What do you cut? In the United States, you might cut defense spending, but there is little to cut in Europe and Japan. Education? Welfare? Parks? Transportation? Medical or health programs for the working? It gets so very ugly. Since such an outcome (50 percent of GDP for pensions) is impossible, long before that type of debacle is reached, other solutions, painful as they are, will have been chosen.

Some other gleanings: A mere 10 percent cut in benefits pushes approximately 5 percent of the elderly population into poverty in Europe-think what a 20 percent cut in benefits would do. Japan is ranked in the middle of the vulnerability pack, despite its poor economic outlook, because more than 50 percent of the elderly live with their children. The three most vulnerable countries are France, Italy, and Spain. Australians are expected to live longer (86.7 years) than any group except the Japanese, who are expected to live to an average of 91.9 years.

In France 67 percent of the income of the elderly population comes from public funding and in Germany it is 61 percent, compared with 35 percent in the United States and Japan. (See Figure 11.4.) These percentages are projected to rise only slightly over the coming decades, but because the elderly population is growing so rapidly, actual outlays will soar. Not surprisingly, if you add in medical costs the percentage of public spending increases significantly, even assuming no new benefits.

Bull’s Eye Investing: Demography Is Destiny

The world economy is currently dominated by the United States, Europe, and Japan. These studies suggest that there will be little or no help from Europe and Japan in regard to world growth. The world is already far too U.S.-centric. Everyone wants to sell to the U.S. consumer. Our international trade deficit for 2003 was over $500 billion, which simply cannot be sustained.

BCA suggests that the Japanese government debt will grow to 300 percent of GDP over the coming decades. To put this into perspective, that would be the equivalent of $36 trillion U.S. debt. Even with zero interest rates, that is a staggering sum. The Japanese economy cannot handle such a deficit without turning on the printing presses in a manner unprecedented for major countries. It is hard to imagine the dollar, as weak as some think it is, to drop long-term (think decades here) against such massive and mounting deficits, which will have to be financed by attempts at inflation.

Europe is already spending a very small percentage of its budget on defense. As one wag puts it, they will be faced with the choice of “guns or rocking chairs.” With a declining population, they will be hard-pressed to find enough bodies to man their military as it currently exists.

Unless they unwind their pension promises, European countries will play a smaller role in the world of the future, notwithstanding the view from France. The role of Asia, especially China and India, will be far more significant in the future world of our children.

The problems outlined in the two studies suggest that turmoil is coming to the developed countries of Europe and Japan. They cannot pay for their promises to retirees and still grow their economies. They will have to choose one or the other. If they choose higher taxes and fewer opportunities, the best of young Europe will vote with their feet, as did their ancestors in the eighteenth and nineteenth centuries. That will only make the situation worse. But can a majority retiring population vote to cut their benefits?

In short, for the world economy to grow, developing countries are going to have to look to themselves for growth. The aging developed countries will simply not provide the growth engine that they provided for the latter half of the twentieth century.

For forward-looking investors, that means there will be real business growth opportunities in the emerging markets and those countries that can sell to them.

As strange as it may seem today, in a few decades China will be complaining about cheap labor in the Middle East and western Asia. If that sounds too far-fetched, think Japan only a few decades ago. The next stock market bubbles will be to the west of our shores.

As BCA noted, it is critical that the Iraqi experiment in democracy be successful for the future stability of the world. In 1945, there were many who thought it would be impossible for the regimented Japanese to establish a successful democracy. Today we watch as China moves to a capitalist economy and democracy. What stock market did the best in 2002? It was Russia, which not coincidentally has some of the lowest tax rates.

Call me naive, but I do not think the primary consideration for the Iraqi war was/is oil, American hegemony, or establishing a democracy in Iraq. But I think that the current U.S. administration intends to use the event to do its best to bring about a thriving Islamic democracy. The Iraqi people are educated and are quite entrepreneurial and business oriented. I expect (or at least fervently hope) that given the chance they may surprise many in the world with how fast they rebound. Given their explosive population growth rate, they could become an engine for growth in the region. If President Bush is serious about helping Iraq, he should get rid of any and all trade barriers with the new regime and stand back and let the free market work.

Only a few years ago, we were fearful of the Chinese hordes and their army. They were the enemy. Today, our economies are so inextricably interwoven that it is in our best interest to work any problems out peacefully. We now depend on each other. If we want to find peace with the Arab world, we need to find ways to establish economic ties with Arab countries as well. If we do not, the demographic issues I outlined earlier will have very negative consequences for us, our children, and our grandchildren.

Finally, if I were young and aggressive or starting out (or starting over) I would seriously consider learning a second and third language, moving overseas, and looking for opportunity. I would learn a business here and go and reproduce it offshore. Or you could consider backing a younger person who has the time and energy to start a business in a foreign country. But be prepared to travel, and even if you are only the investor, learn the local language and customs and be ready to change course quickly.

John Mauldin
March 31, 2005