The Strength of the Recovery: Demographics could kill it all.

Mussa gave an interesting talk on the recovery the other day at the Peterson Institute. You can find his paper on their website. He makes an excellent case for a V-shaped recovery. With his forecast of U.S. growth at 4.5 percent for 2010, he makes the claim that his estimate is actually conservative. That, in reality, we could, and likely should, look for an even steeper recovery. In particular, he points to the fact that in the average post-war recession average growth has been closer to 10 percent than 5.

In my last two posts, I gave a cycle-by-cycle breakdown of the key parts of GDP. The rate of recovery in individual components was not particularly strong. Adding up the various measures, the strength of various recoveries was accomplished because most of the rising demand coming out of recessions was satisfied from domestic sources. In this recession, any rising demand is likely to be satisfied to a large extent by production outside of the United States. Just as the downturn in the United States was cushioned by a fall in imports the rebound will be pushed down by imports.

But, in my mind, this is all accounting. The potential U.S. recovery is exposed to a much more serious threat: the U.S. consumer. In percentage terms, the rise in the savings rate in this recession far exceeds the rise at any other time in post-war history. Indeed, we have to go back to the 1930s to see a similar spike. Prior to this recession but still post-war, the largest increase in the savings rate was a little more than 30 percent. In this episode, the increase has been a little more than 80 percent. Granted, the calculation is from a very low base near 2 percent of income.
However, never in post-war history has consumption accounted for such a large portion of aggregate demand. I believe the large change in savings reflects a combination of cyclical forces and the beginning of a long-term consumer retrenchment. Americans must consume a smaller portion of their income.

With 1 in 6 Americans underemployed and with wage growth falling, consumption is likely to be a substantial drag on any recovery.

Yet, I believe Mussa would retort (he makes the argument in his paper) that consumption has fallen more than in any other recovery and we are due a bounce back. Indeed, so Mussa would say, following the recession of 1980 consumer spending bounced back with a vengeance.

Take a look at the following picture. Despite the financial crisis aspect of this recession, consumer credit was unimpaired relative to previous recessions. Real consumer credit has only nudged down. Compare this to the almost 15 percent fall in 1982. In 1982, real interest rates rose to record levels. Consumers stopped spending. Following the recession, the expansion of credit played a huge role in the rapid expansion of spending. Consumer credit grew at almost three times the pace of the average recovery. With almost no impairment in this recession, the room for a bounce back is smaller.

The resumption of consumption also faces a very unfavorable demographic situation. The chart below shows prime-age workers (30 to 65) as a percent of the total population. In 1982, this group of agents increased almost 8 percent over the first five years of the 1980s. In the current recession, this percentage falls remarkably over the forecast. Indeed, it falls faster than at any other time since at least before 1901. Prime-age workers are the most productive people in the economy. They also spend the most: they buy big houses and fancy cars. A fall in this group has wide-spread implications for the economy. There is only one other country I know of with this demographic pattern: 1990s Japan. That is not a good omen for V-shaped recoveries.

Just to finish the thought, here is the path of prime-age workers as a percent of the total population from 1970 through 2014. It seems that one source of our amazing growth rates from 1980 through 2007 was the rise of this group of workers. Notice, that during the productivity slowdown in the 1970s, this group of workers was flat or falling. During the 2000 recession and long jobless recovery that followed, this group of workers was also quite stagnant. For the next ten years or so, these workers will retire out of the labor force.

Most model-based forecasts assume that the fall in population itself will subtract only a few tenths from growth. With labor shares and capital constant, this is true. However, the fall in prime-age workers is also likely to be associated with a long-term downward trend in investment. We have already almost a decade of subpar investment growth. More importantly, the loss of human capital will be severe. It takes years to produce prime-age workers. These workers embody skills that have been acquired in a life-time of work. There loss is likely to drag on labor productivity for the foreseeable future.