What Secular Stagnation?

Note: this is probably the shortest post I've ever written

According to Larry Summers, secular stagnation is supposed to be reflected in the continuous decrease of bond yields since the early 1980's (the increase before can be explained in a simple way-inflation):

Yet, we usually forge to have a look at these:

Now remember where bank capital and most of the funds of the pension funds industry are (most times forced by legislation) invested: Bonds. I'd also like to remind some of the supply and demand premise in economics: when supply of funds increases then price increases and thus the yield decreases. And we are on a continuous search for safe assets to invest in. As the safest of all are government bonds (explained here) the increase in life expectancy has forced pension funds to invest more and more assets in the bond market (for a more detailed view of pension systems and population read this).

Concluding, I do not believe that stagnation can be inferred from bond yields. Declining returns just mean that the supply of funds for bonds has been stronger than demand and this is what's driving yields down. Now if that can affect the economy is a different story (one which I do not really trust to be honest since the US has been growing steadily since the 1980's), yet it does not indicate stagnation on its own. It just shows that when times are bad, people come up with a lot of explanations about what's at fault. But then again, I might be wrong and Summers could be right; time will tell.

Pension Systems in Declining Populations

Pension Funds

The global asset management industry has been booming over the past decade. Only in 2012 assets under management were up by 9% reaching $87.2 trillion. Of that, approximately 40%, or $33.9 trillion, were held by pension funds. To get a grasp of the size these funds the graph on the right indicates their sizes relative to GDP. As one can easily observe, pension fund assets in the UK and the US exceed 110% of GDP while they account for approximately 50% of the world's GDP.

Figure 1

Although many countries (according to the OECD) are still mainly funded through public pay-as-you-go (PAYG) systems (Pillar I), a shift towards mandatory private pension funds (Pillar II) and voluntary ones (Pillar III) is observed. The increased popularity of privately-held pension funds can be attributed to a more "free-market" view of the world; the private sector can do it just as well as the public sector so why not let the former do all the job? The private sector has done its job excellently so far: pension funds usually focus on relatively conservative investment strategies (a comment from someone in the industry was "we are playing with people's retirement so we focus on low-risk products") and although their allocation has been increasingly focused on bonds and bills as the following graph shows, their returns have been relatively good for the 3-year average (see the OECD publication for details).

Figure 2

Although the fact that the private sector is doing its job very well may suffice as an excuse on the tremendous growth of  pension funds, reality offers additional justification: people are expected to live much longer than they did half a century ago thus they require more money to preserve a decent standard of living for longer (FlipChartRick has an excellent article on Pieria concerning the changes in distribution of the UK population since the 1900's). Additionally, the growing population of the elderly increases fears of PAYG systems facing trouble with funding. Compliment that with a slight need humans have to earn more and more (commonly known as greed) and the need for pension funds is increased.

Yet, what we have failed to observe is that focusing purely on the private sector to provide funding has its own issues. The PAYG system mainly took contributions from workers and passed them on to pensioners, investing the rest in government bonds. This basically means that nothing in the economy changes by much: what contributors lose, pensioners get and the remainder is returned to the people via government spending. Government spending can (and does) increase consumption, yet as David Ricardo noted "In point of economy there is no real difference in either of the modes, for 20 millions in one payment, 1 million per annum for ever, or £1,200,000 for forty-five years are precisely of the same value". In essence, although an increase in government spending can produce short-term increase in consumption, the government will eventually have to lower consumption to repay for the loan. (obviously this does not take into account multiplier effects which propagate the increased consumption shock and, with the assistance of the private sector make the shock last longer. Yet, if we strictly look at just government spending the above holds)

As Figure 2 shows, private pensions, just like PAYG, take contributions, pay out the pensioners and use the rest to invest. Yet, the investment strategy is much different: although both invest in bonds and bills, pension funds also invest in property, equity, derivatives and hold a significant amount in cash. Although funds hold about 20% of their assets in equities, the sheer number of that investment is astonishing if one remembers the total size of the market. As stated before a protracted period of increasing prices rises the money supply in the economy. In addition, as property is becoming more and more important given its "safety", more funds are allocated there, resulting in increased demand and higher prices. The following two graphs are indicative of the correlations of pension funds and housing:

Figure 3 Case-Shiller Housing Price Index

Figure 4

Although Figure 3 dates from the 1890's, the sharp drop in 2007-2008 can easily be seen, just like the one Figure 4. The drop would have been more visible in Figure 4 had I been able to find assets in dollars and not as a percentage of GDP. The reason is that US GDP also fell drastically during that period and thus although assets took a tumble the result is much less steeper than it should have been.

In general, it seems that private pension funds are actually contributing to inflation by increasing property, equity and bond prices (while reducing their yields). As the quest for safe assets becomes more and more intense, with pensioners increasing every year, the need to invest money in order to obtain a return which would make the fund sustainable makes bonds and property more valuable than ever before. This, as mentioned before, increases prices (and lowers bond yields) thus making money supply increase. 

As Charles Hugh Smith notes if yields are falling how will pension funds continue to exist, especially if the elderly population increases? The answer will most probably be through property and equity, which will create a short-term boost to their returns. Will this be permanent though?

Declining Population

Suppose that we have 100 units of currency in a population of 100 people, each person owning a unit. Suppose now that in a few year's time, the population is decreased to 80, now with each person owning 1.2 units if money is stable. Would that mean that consumption is decreased? The answer is that it depends. If people tend to spend more than before then consumption might not be reduced. Yet, even if consumption per capita increases it will occur at a diminishing rate. It has long been the case (Kuznets, 1955) that people spend less of their income as their income rises. In simple terms, even you are making a million a year you will probably not be buying a new TV every 2 months to compensate for the lack of demand. 

In this scenario, superabundance is rapidly reached: more than enough goods for every human being, yet with declining demand. Declining population will have many interesting side-effects: as already mentioned long-term rates are greatly affected by the rate of population growth. Yet, if population growth is zero or negative it will mean that these rates will also become negative or zero. My guess is that they will fluctuate on slightly positive ground if population is stable due to liquidity preferences and they will be less negative than the rate of change of the population if it is negative, for the same reason. Whether this is enough to compensate for the increased percentage of the elderly in total population and the increased need for safe assets which will make bond yields even more negative is to be seen.

Interestingly enough, in such a scenario inflation is not out of the picture. As the elderly consist of a growing part of the population and long-term bond yields tend to zero or negative, more investment in real estate and equity will occur, resulting in a rise of property and stock prices thus creating a boost in money supply. This will lead to an environment of short-term inflation due to money supply increases either through private actions like the ones described here or through public ones, i.e. printing. In such an environment banks will have a diminished role: less demand for lending will essentially mean less bank-created money.

If one thinks of a yield curve in this scenario then it would have to be an inverted, gradual-sloped one, at times resembling a fixed curve. Rates should be slightly positive in the short-run due to inflation persistence, while in the long run they should be more prone to negative values due to a decrease in population (even though the decrease in population would equal the long-run rates as already stated).

A suitable question is why shouldn't the long-run rates be positive given that we have inflation in the short run. The answer is that if population will continue to fall then the above-mentioned inflation, driven by property and equity, cannot persist for much longer. As the number of people on the planet is reduces, demand for property is also reduced and more land is available, forcing prices to fall. If this is the case, and no government intervention occurs, then the (very) long-term trend of inflation will be negative. Even at that, the short-term rates will be higher than the long-term ones. As inflation reaches approximately zero, short-term rates will reflect just that, with expectations of inflation being that the trend will stabilize. At that time, long-term rates will continue to be negative and follow the trend of population growth.

What is most likely is this environment is that markets will basically break as nobody would wish to invest in an asset which is losing its value. With working population shrinking, the only remedy I can currently think of is an increase in the retirement age, just like it is being done in most Western countries. Yet, even this has important considerations in the long-run: our bodies are not designed to work until their late 70's (unless we are talking about non-intensive work in which again productivity is reduced) and we cannot view this increase in retirement as a panacea. If abundance through automation is not achieved times might just get more difficult, with inequality rising to new heights.

Savings, Inflation and Social Security: Why Savers Shouldn't Complain

Although I may be a bit too late to join the discussion of whether savers should be saved from rising prices I will add my two cents to it. The whole idea started when Frances Coppola published her first article on the subject arguing that savers should not be compensated for any loss as a result of increased inflation with John Aziz noting that if savers wish for higher returns they should not invest in cash. In response, Save our Savers basically commented that savings are important and they are a driver of investment which promoted another response by Frances Coppola on how savings and investment actually work in an economy. Although this may not come as a surprise I actually agree with Frances on the subject and I will try to put it as simply as possible, using a paper by Paul Samuelson in assistance.

Imagine an economy where people tend to have two possible states: they are either producing or they are in retirement. Of course, there are those who are not producing and are not in retirement, such as children but we can account for them in the consumption of the workers (in the sense that retired people usually do not have to support children while other adults usually do). When people retire they cannot produce any more (which is more or less true in real life as well). Another assumption here is that goods cannot be stored with ease; basically the young cannot store goods for their retirement. This becomes more easily understood if we think of it this way: we cannot store apples or meat in our 30's or 40's to consume in our 60's and 70's. The same would hold for almost any other good which can be consumed.

In the absence of money in this economy, the old would starve to death as soon as they reached their retirement. The reason is simply that young ones have no incentive to decrease their consumption and give some to the old as they cannot know that the future young will do the same. In fact, they already know that the future young will not do the same. In this society, the old have nothing to hope as soon as they reach retirement.

There are only two ways that such a situation can be remedied: if we introduce some sort of legislation forcing the young to give to the old or if we introduce money as a store of value. Let's start off with the latter. Here, money has the basic purposes of serving as a store of value and a medium of exchange, having no consumption value on its own. By introducing currency in the economy we are making the elderly much better off: we are allowing them to save when they are young and have some wealth to consume when they are old. In the absence of a good which can be stored, consumption cannot be postponed. As we introduce money, people can, and is to their best interests to, postpone current consumption for consumption in the future if they do not wish to die of starvation when they reach retirement age.

This situation appears to be quite similar to the one we face now: savers have been saving through their working lives and are now using their savings to consume. Yet, in this model, the big bad wolf is inflation: in this simplistic economy, prices can be shown to rise at the rate of population growth which can be shown to be higher than the interest rate, if no other variables affect the rate (see the Samuelson paper for details). In real life, inflation is in many cases higher than the rates paid by the banks for many other reasons, in addition to population growth. This means that the value of savings is reduced (or increased) each year by the difference between the interest earned and inflation rate.

Thus far I do not believe that anyone would disagree with the analysis. This is where things get interesting: as the reader may recall, we have specified two actions which can make the situation better for the retiree: one was the introduction of money and the other was legislation. This legislation, in the absence of money in the economy, would force the workers to hand over some of their consumption to the old so that they would not die when they reached retirement. This is basically what we call the pay-as-you-go system which is dominant in state-funded pension systems. Basically what is done is that the state takes from the workers and gives to the retirees based on what the retirees had given when they were themselves workers. This, solves the problem of providing for the retirees in the absence of money.

Remember this though: in our world, both a unit of currency to store and exchange and a social security system exists. Thus, we are in fact using the best of two worlds, combined: we give our workers both the opportunity to save when they are producing and we also provide them with added benefits of pensions (i.e. consumption moved from the young to the old) when they retire. Thus, not only are they not losing money when prices are rising but they are in fact gaining: they have had the opportunity to save and enjoy their wealth later but they lose something which is probably 1-2% per year on their savings. Yet, most of the times (and the exceptions are those with extraordinarily high savings), pensions are more than compensating for that loss. Not only are they compensating for that but most pensions are usually inflation-adjusted at some point which makes retirees earn even more, not to mention what happens when the difference between interest and inflation is positive.

A numerical example should shed more light: a retiree has 100,000 units of currency in the bank earning 0% of interest, while the inflation rate is 3% per annum, at a loss of 3,000 units of purchasing power per year. Although in this case the bank rate would almost certainly be higher we can show that even in this extreme case the saver is earning. If the saver earns 12,000 units of currency as his pension each year, the loss of 3,000 is more than made up for. The retiree would have to earn less than 250 units of currency as his pension each year to face losses, even from such an extreme scenario.

One question which might spring to mind is why am I not dealing with workers or employers who have savings. The simple reason is that the increase in inflation will increase the nominal amount of their earnings sooner or later. Even if the transmission mechanism of inflation to salaries or profits is not perfect and not fully flexible it will be evident sooner or later; besides, just as this transmission mechanism is not perfect the same holds for the one moving interest rates with inflation.

The simple story this post is trying to make is that inflation should not worry the retired. As we have seen, our world is in fact using two schemes which safeguard their wealth: social security schemes and money as a store of value. If only the latter was employed, then people would lose purchasing power in times of higher prices. Yet, their combination safeguards us from such an outcome. Concluding, savers are complaining for no reason at all: their savings may lose purchasing power from inflation occasionally but they are more than compensated for that from their paychecks at the end of each month.

Resistance to change: 3 reasons Unions and the Public are unreasonable

One of the usual pieces of news in the EU (especially in the South) is that spokesmen from various trade unions declare that they will not accept/negotiate/give in to the reforms that the Troikans or the nations' governments (or both) are proposing. It is my opinion that in order for the spokesmen/leaders of several organizations to appear powerful, they indulge in a game of what in economics is called an "incredible threats" (an incredible threat is a situation where somebody would threaten to do something that would harm himself as well as the other. Rational people would never choose to propose nor do any of those threats. An example is: a person enters your car and threatens that if you do not give him money he would blow your car with him inside it.) These are the reasons why I consider the aforementioned threats are incredible (or irrational):

1. Neither the Unions nor the Member-States requesting bail-outs are in a proper position to negotiate, since they are not considered credible any more. The lack of credibility derives from the fact that during the crisis their actions had been close to none. The only countries which are currently trying to restore market confidence are Italy and Greece. Only after their creditors are convinced that much has been done by their respective leaders will Italy and Greece (especially the latter) be able to negotiate. That is exactly what the Greek Prime Minister is trying to accomplish at the moment with harsh austerity measures which will allow him to expand the austerity horizon by 1-2 years. One may easily realize that if a national leader is not able to negotiate, the Union leaders or spokesmen have even less ability to do so. (In a similar note, the Cypriot GDP contraction is expected to be 1.5% in 2012 rather than 0.5% as it was originally estimated, another incredible estimate from Cyprus)

2. Not imposing any reforms or other austerity measures is even more irrational than imposing a lot rapidly (e.g. Greece). Blame for the current situation in Greece can only be assigned to the Greek politicians who had been overspending over the last 10-20 years. The political system in Greece was correctly defined as Kleptocracy rather than democracy. Both Italy and Greece are considered more corrupt than all of the other EU nations, where Cyprus, Portugal and Spain are just above average. In order for the crisis-ridden states to move forward and hope for a better future many necessary reforms should take place, notably concerning the public sector size and pay-scale. Reforms should also promote more transparency, so that nations may regain their lost credibility and their people will start believing in them again. (A major issue both in Italy and Greece)

3. Union leaders and others believe that when salaries, wages or benefits decrease, their lives will be more difficult. Although this may be partially true in the short run, (up to 6 months) in the long run, prices will adjust to the lack of liquidity (i.e. money) in the economy and they will subsequently fall. Let's use Greece as an example here: the proposed austerity measures state that the cuts will be 2% for pensions of up to 1,000 euro, 3% for pensions from 1,000 to 1,300 euro, 5% for pensions from 1,300 to 1,600 euro, 10% for pensions from 1,600 to 2,000 euro and 15% for pensions of 2,000 euro and more.  This would mean that all prices in the Greek economy would drop (though not from one moment to another, although much faster than any other other nation), which may even raise the standard of living for the Greeks.

People cannot distinguish between nominal and real income. Neither can economists in their real life. Obviously people would like to see their salaries and benefits rise in perpetuity regardless of prices. However, this is not rational thinking as with a 3% inflation and a 2% rise in wages people would be worst off. This was exactly what had happened over the last few years after the introduction of the Euro in the Southern EU nations. (for more details see here)

Although it may appear to be unthinkable to many, especially those who are -erroneously- relying on the state to cover their expenses, accepting the reforms and  austerity measures will be the only way forward.