A contracting workforce means tepid economic growth for advanced economies

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Article Highlights

  • The financial crisis hit at a very inopportune moment for western economies: During a global demographic transformation.

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  • In the US, the population aged 65+ is set to increase from 41 million in 2010 to 73 million in 2030.

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  • Workforces around the world are now barely growing and, in some countries, are about to shrink steadily.

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  • With a shrinking workforce, potential growth is expected to be far, far below historical levels.

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Editor's note: This text was originally published at www.fletcherforum.org

The financial crisis hit at a very inopportune moment for western economies. Of course, there’s never a good time for a 5.1 percent of GDP contraction, which is what occurred in the U.S. over an eighteen-month period starting in late 2007 and continuing into mid-2009. But this was particularly bad timing because the U.S. and other advanced economies were already in for a rough ride over the coming two decades due to the unprecedented demographic transformation that is now well underway globally. The deep recession erased trillions of dollars of wealth just as these countries should have been setting aside massive amounts of resources to prepare for coming economic storms.

It is fairly well understood at this point that global aging is, and will be, creating tremendous fiscal pressure in the advanced economies. In the U.S., the population aged sixty-five and older is set to increase from 41 million in 2010 to 73 million in 2030, according to the Social Security Administration. This is a big reason that federal spending on Social Security, Medicare, and Medicaid is set to jump from about ten percent of GDP in 2010 to fifteen percent in 2030, using plausible assumptions from the Congressional Budget Office. Similar population trends and budgetary pressures are underway throughout the developed world. Indeed, the expectation that Greece, Italy, and Spain are wholly unprepared for the massive health and pension spending commitments coming their way is partly to blame for the debt and euro crises still hanging over the continent.

But what is less discussed, and thus less well understood, is the effect of demographic transformation on economic growth itself. The problem is not strictly that the governments of these countries will be shouldering large obligations associated with a growing elderly population. It is also the fact that these countries will experience very low growth by historical standards because their workforces will be either stagnant or shrinking.

Total economic output can be expressed mathematically rather simply. Total GDP is the product of the number of workers in the formal economy and the amount produced per worker. It follows that yearly growth in GDP is a function of change in the size of the workforce and in productivity (i.e., the amount produced per worker).

For decades, Europe, the U.S., and other advanced economies have enjoyed strong growth because their workforces have been growing and capital investment and technology have allowed workers to produce more and more each year. That is now changing, however. Productivity is still improving, but workforces around the world are now barely growing and, in some countries, are about to shrink steadily for the foreseeable future.

For instance, according to 2006 projections from the European Commission (EC), the size of the EU-wide population in their prime working years—those aged fifteen to sixty-four—was about 307 million in 2004. By 2025, the EC expects that number to have fallen to about 296 million people, and by 2050 to about 255 million people.

This shrinking workforce will dramatically slow economic growth. From 2004 to 2010, the EC projected that potential GDP growth was about 2.4 percent annually, assuming near-full employment. That’s because the full-employment workforce was still growing at about 0.9 percent per year during those years, and productivity was expected to rise about 1.5 percent annually.

But with a shrinking workforce, potential growth is expected to be far, far below historical levels. The 2006 EC report projected that the EU-wide workforce contraction would average about 0.1 percent per year through 2025. Even if productivity improvement grows to 2.0 percent annually, overall growth—1.9 percent each year—would still be well below what it has been historically. And it will only get worse over the longer term. From 2025 to 2050, a dramatically contracting workforce will drag average growth down to 1.2 percent annually—making it impossible for Europe to generate the resources necessary to finance the burdens of improved longevity.

The situation in the U.S. is not as dire as Europe’s in large part because the fertility rate in the U.S. has been above Europe’s for the past few decades. The Social Security Administration’s projections show the population age twenty to sixty-four growing modestly from about 190 million today to just over 200 million in two decades. That’s far below the growth rate in the prior two decades, when the number of working-age Americans rose by about 40 million people.

Most commentary on demographics focuses on population aging, which is of course a major concern. But the demographic shift that is now underway is the result of two trends: longer lifespans and falling birth rates. And low birth rates always lead, eventually, to shrinking workforces. Over the longer term, it is the gradual decline in the size of the labor force across the developed world that is likely to cause the most strain.

Economic studies have linked reduced birthrates to growth in old age pension and health benefits and the rising taxes associated with financing them. Western governments should therefore consider reducing the tax burden on young workers who are forming families. In the end, it may be difficult to overcome the powerful cultural forces that are pushing down birth rates in the developed world, but there is nothing to lose and much to gain from trying.

 

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James C.
Capretta

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