The Marin Post

Blog Post < Previous | Next >

• International
|
• Government Finances & Taxes

Aging Demographics and Unsustainable Fiscal Leverage

Within this essay, I review the impact of demographic aging on the US fiscal position. And, I compare the US to Australia, France, Italy, and Japan. All those countries have a similar level of economic development as the US. Some of them are very similar to the US in terms of demographics aging or deteriorating fiscal situation. This group of countries will provide good benchmarks to evaluate the US fiscal management proficiency (or mismanagement, as we will see).

The mentioned countries are each interesting for specific reasons.

• France is undergoing substantial fiscal stress. Their President has just raised the eligible age for Federal pension retirement from 62 to 64 years. He indicated doing so was necessary because France's fiscal situation is otherwise unsustainable.
• Italy is well known as the fiscal basket case of Western Europe with the highest Federal Debt to GDP ratio within the region. This is in part due to Italy having a rapidly aging population combined with stagnant economic growth.
• Japan is known as the fiscal basket case of Asia with the highest Federal Debt to GDP ratio among developed economies. This is in part due to Japan having the oldest population among major countries. Japan also has a rather flat economic growth over the long term.
• Australia is not known for any fiscal flaws. Instead, it has an aging demographic profile quite similar to the US. Both populations are relatively young when compared to the other countries. It also has fairly robust economic growth, competitive with the US one.

In combination, these countries will provide interesting benchmarks to evaluate the US fiscal management performance given its demographic profile.

Data source

For demographics data, I used the website Our World in Data. It extracts demographics data from the United Nations, World Population Prospects.

For fiscal data, I used FRED from the Federal Reserve Bank of St. Louis.

Life expectancy is rising everywhere

By itself, rising life expectancy is a very good thing. It is a dominant indicator of a country's health and wellness of its citizen.

In the two graphs above, there are several noteworthy trends:

• Back in 1950, the US (black line) had close to the longest life expectancy at birth at 68.1 years. By 2021, the US life expectancy rose by a full 9 years (77.2 years); but, it is now a very distant fifth compared to the other countries whose respective life expectancy has risen to between 82 to 85 years old.
• Notice Japan's most rapid increase in life expectancy from 59.2 years in 1950 to 84.8 years in 2021 (red line).
• When looking at life expectancy at 65 years old, the trends are similar. Between 1950 and 2021, the US went from first to last place. And, Japan went from last to first place.

Rising life expectancy = demographic aging

Rising life expectancy is a very good thing. However, it contributes to demographic aging. The latter, as we shall soon see, puts much stress on a country's fiscal position.

Trends of interest within the above graphs:

• Again Japan is a standout. Its rapid rise in life expectancy has contributed to an equally rapid rise in demographic aging captured as the % of the population over 65 and the Median age of the population.
• Italy's Median age has risen nearly as rapidly as Japan's. In 2021, Italy had a Median age of 46.8 years vs. 48.4 years old for Japan.
• Australia and the US have very similar demographic aging curves. In 2021, Australia's Median age was 37 years and the US was 37.7 years old. These Medians are very similar to Japan and Italy back in 1992 or 29 years earlier!
• France aging demographic curves fall in between the rapidly aging (Italy and Japan) and the much more slowly aging (Australia and US).

Demographic aging = rise in Old-Age Dependency Ratio (OADR)

The numerator of the OADR is the number of individuals over 65 deemed in retirement. The denominator is the number of working-age individuals (15 - 64). The higher the OADR ratio, the fewer working-age individuals you have to support the retirement of the elderly. That is the essence of the aging demographics stress on a country's financial position.

Trends of interest within the graph above:

• Again Japan shows the most rapid increase. Back in 1950, it had the lowest OADR at only 0.08. Thus, it had about 12 working-age individuals to support one single retiree. However, in 2021, its OADR was 0.51. Thus, it now has just 2 working-age individuals to support one retiree.
• Notice again how Australia's and US's respective curves very much overlap. They are associated with a far slower increase in that ratio.
• Notice how Australia, US, and Italy all started at the same level with an OADR of 0.125 back in 1950. However, Italy's ratio increased far faster than Australia's and the US's. This is because Italy's aging, as shown earlier, was also far more rapid than in Australia and the US as it nearly matched Japan's.
• Australia and the US's OADR at about 0.25 in 2021 is at the same level as France in 2004, Italy in 1997, and Japan in 1999.

An indirect way to capture demographic aging

You can also capture demographic aging by focusing on the Net Migration Rate and the Natural Population Growth Rate.

Net migration equals the number of individuals who come into a country minus the ones who leave a country.

Natural population growth is equal to births minus deaths.

Both variables are converted to a yearly percentage of the total population.

Trends of interest within the two graphs above:

• The Net Migration Rate (on the left) has declined fairly rapidly for most countries over the most recent decade.
• In 2021, Net Migration Rate is very close to Zero for both Italy and Japan. And, it is getting close to Zero for the US.
• Since 1950 the Natural Population Growth Rate has rapidly declined for all countries. It has turned negative for both Italy and Japan since the early to mid-2000s.
• Regarding those two variables, Australia has a more favorable demographic profile than the other countries. You can see that its respective curves (orange) reflect a much higher Net Migration Rate and Natural Population Growth Rate than for the other countries.

Let's look at the impact of COVID on Life Expectancy

This is a very short detour unrelated to the main topic. But, it is too interesting to ignore. In a nutshell, COVID had a far more severe impact on the reduction of US life expectancy than for other countries.

COVID impact trends:

• The US life expectancy (left graph) dropped from 79.1 years in 2019 to 77.2 years in 2021(a drop of nearly two years). All other countries held up far better on this count. Australia even gained 1.4 years in life expectancy over the same period (83.1 to 84.5 years).
• When focusing on life expectancy at 65 (right graph), the trends are similar. Between 2019 and 2021, the US lost 0.9 years in life expectancy at 65. Meanwhile, Italy lost 0.4 years; Japan and Australia remained flat.

Aging demographics impact on the fiscal condition

A country with an older population has more retirees who increase fiscal costs (retirement, health care costs) and fewer working-age individuals who pay into the system through payroll taxes and income taxes. As a result, an aging population causes:

1. A rise in Government spending (higher pension and healthcare costs);
2. A decrease in Government receipts (lower payroll and income taxes receipts);
3. Rising Budget Deficits; and
4. Rising Government Debt/GDP ratio.

Items 1 and 2 cause item 3. Item 3 causes 4.

The above explains a very strong causal relationship between demographics aging and rising fiscal leverage (rising Debt/GDP).

What does the demographics profile tell us about relative fiscal stress?

When focusing on demographic variables alone, Japan is under greater fiscal stress as its population has aged so rapidly. And, it has by far the highest OADR (0.51). Italy comes in a distant second (OADR 0.37). France comes in a close third (OADR 0.35). And, Australia and the US come in with by far the lowest OADR at around 0.255.

As reviewed, we can already anticipate that demographic trends go a long way towards explaining that Japan is the fiscal basket case of Asia and Italy is the one of Western Europe. On a relative basis, both Australia and the US should be in far better fiscal shape than the other countries because of their far younger populations and their resulting far lower respective OADR. As we will see when it comes to the US, demography is not destiny. Fiscal mismanagement plays a role too.

This concludes the demographic section. I will move on next to the fiscal condition.

What is a reasonable fiscal condition?

In 1992, the European Union agreed on parameters that would define a country's satisfactory fiscal condition (the Maastricht Treaty). These parameters included:

• Budget Deficit/GDP = < 3%
• Federal Government Debt/GDP = < 60%

The above parameters make good sense. They would ensure that:

1. Yearly budget deficits would remain reasonable;
2. A country's debt level would remain under control; and
3. A country's fiscal condition would be sound and sustainable.

As we will soon see the majority of countries have deviated wildly from these desirable parameters of fiscal soundness. These fiscal divergences even include countries that are subject to those criteria as they are members of the European Union (France, Italy).

Budget Deficit

Budget Deficit graph interesting trends:

• Even at the onset of the Maastricht Treaty in 1992, Italy failed the Budget Deficit = < 3% of GDP threshold by a very wide margin. Its Budget Deficit was 10.1% of GDP in 1992. Between 1992 and 2022, Italy met the 3% criteria only half the time (or 15 out of 30 years). Its average Budget Deficit was - 4.4% during these 30 years.
• France's fiscal record is also very bad. It failed the 3% Budget Deficit limit in 22 out of 30 years. But, its Budget Deficits have been smaller than Italy averaging - 4.1%.
• Japan has by far the worst Budget performance. It meets the 3% standard in only 3 years out of 30. And, its average Budget Deficit is very high at - 5.5%.
• Australia has by far the best record. It meets the 3% standard in 21 out of 30 years. Its average Budget Deficit is reasonable at - 2.0%.
• The US Budget Deficit performance is fairly close to the European countries. It meets the 3% standard in only 14 years out of 30. And, its average Budget Deficit is - 3.7% or not that much smaller than France.

The demographic trends turned out to be highly predictive of Budget performance. Japan with the highest Old-Age Dependency Ratio (OADR) achieved the worst Budget performance, followed by Italy (with the second highest OADR), followed by France (third highest OADR), followed by US (fourth highest OADR), and finally Australia (with far the best and lowest Budget Deficit levels).

However, even after adjusting for demographic factors, the US Budget performance is really poor. It has a relatively young population, very similar to Australia. Yet, the US Budget performance resembles far more the ones of European countries with far older populations than the US.

The two graphs below show the Budget Deficit performance during the two most recent crises: the Great Recession (left graph below) and the COVID crisis (right graph).

Interesting trends regarding the two Budget Deficit graphs above.

• During the Great Recession, the US Budget Deficits (black line) lined up very closely with Japan (red). They are far bigger than the other countries. Demographics suggest US Budget Deficits should have been far smaller and very much aligned with Australia (orange).
• Italy (green) surprises at the other end. You would have expected its Budget Deficits to be closer to Japan's levels than Australia's.
• During the COVID Crisis, the US Budget Deficits are a lot larger than anyone else. They reach a record level of 14.9% of GDP in 2020. This is 5 to 6 percentage points higher than for all the other countries.

As mentioned earlier, when it comes to the US demographics does not explain a whole lot. Its fiscal performance resembles much more the ones of countries with much older population than Australia which has a population of a similar age as the US.

Federal Government Debt/GDP

As shown in the graph below, Australia is the only country that would meet the Debt/GDP = < 60% standard during the majority of the reviewed period. Italy fails that standard since the beginning of this data set in 1980. France fails it since 1996, Japan since 1983, and the US since 1992. Once a country's Debt/GDP exceeds that standard its Debt/GDP ratio keeps on rising the majority of the time getting further above the mentioned standard.

Interesting trends within the graph above:

• Japan's rapid rise in Debt/GDally spectacular. It so much replicates its equally rapid rise in all demographic aging metrics that we have seen earlier.
• Australia's slower rise in Debt/GDP reflects the favorable demographic impact of its younger population.
• The US Debt/GDP curve very much overlaps France's. Again, this suggests fiscal mismanagement on the US part, as its demographics are far more favorable than France including a far younger population. Given the reviewed demographic profiles, we would expect the US Debt/GDP curve to overlap with Australia's, not France's.

Next, let's look at the Debt/GDP ratio during the Great Recession and the COVID Crisis.

Looking at the two graphs above, we could repeat the narrative regarding all the mentioned explanatory trends regarding Budget Deficits. As predicted by demographics, Japan has the highest Debt/GDP ratio, and Australia has the lowest. But, again confirming some level of fiscal mismanagement, the US curves overlap with France's. Meanwhile, we would expect them to overlap with Australia.

However, the two graphs above indicate another critical factor: from a fiscal standpoint all reviewed countries never recovered from the Great Recession! Let me explain. It makes perfect sense to implement expansive fiscal stimuli during recessions. This is to prevent a recession from turning into a depression (this was a serious concern during the Great Recession). During such periods, Budget Deficits and Government Debt levels rise. That's perfectly fine. But, once an economy has recovered Deficits and Debt levels should come back down. However, see in the graphs above that the Debt/GDP levels for all countries were substantially higher in 2019 than they were a full decade earlier when the COVID recession had abated. That is not good. Debt/GDP levels should not keep on climbing in an upward staircase pattern with a big step during each recession without any downward steps during long economic expansions. During a long economic expansion, following a recession, Debt/GDP ratios should come down reasonably rapidly to create fiscal capacity to fend off the next recession. This fiscal reset has not occurred for any of the reviewed countries the majority of the time since 1980 (onset of the data set).

Except for Australia, all other countries' Debt/GDP ratios are on an unsustainable path as they are most likely going to keep on rising forever even in the absence of recessions.

The mechanics of perpetual rising Debt/GDP level

The mechanics of perpetual rising Debt/GDP levels are simple. They can be defined in a simple expression:

Budget Deficit + Interest Rates > Nominal GDP growth

If a country runs a Budget Deficit of 5% and pays 3% of interest on its Debt, if this same country's nominal GDP growth is less than 8%, the country's Debt/GDP ratio will increase forever. That is pretty much the path that all reviewed countries are on right now (except for Australia. Several headwinds will make it likely that Debt/GDP ratios will continue rising. These include:

1. Demographic aging will continue for decades if not a century.
2. Economic growth is slowing down. With slower demographic growth, consumer demand slows down, and so does capital available for investments. This also causes a slowdown in labor productivity.
   
3. The current rise in interest rates will put upward pressure on Budget Deficits and Debt/GDP ratios for years.
   

Demographic and economic growths are interrelated. They represent a very strong reinforcing feedback loop.

Benchmarking the US fiscal performance adjusted for demographics

This is a summary focused on the US fiscal performance using the analysis of demographic and fiscal trends reviewed above. Here, I focus on just three countries: US, France, and Australia. Together, comparisons between these three countries will highlight how divergent the US fiscal performance is. Within the two graphs below I focus on two causal variables:

1. The Old-Age Dependency Ratio (OADR). This captures the stress that demographics impart on a country's fiscal condition;
2. Median Age that reflects the overall aging of a country's population.

The above two causal variables are anticipated to be predictive of the target variable: Government Debt/GDP ratio.

Why the above graphs convey a rather disturbing picture of the US fiscal management:

• The graphs on the left show that the US demographic profile is very similar to Australia. Both those countries have a relatively favorable demographic profile indicative of a population that is a lot younger than France's.
• The graphs on the right, however, show that the US Government Debt/ GDP ratio pretty much overlaps with France's; that is despite the US having a population that is a lot younger than France. The US Debt/GDP curve should instead overlap with Australia. But, it does not.

A second way to study those relationships is to use scatter plots.

Within the above scatter plots, the causal demographic variables (OADR and Median Age) are represented on the X-axis. And, the target variable, Government Debt/GDP is represented on the Y-axis.

The scatter plot on the left indicates that both Australia and France have a nearly identical relationship between the OADR and the Debt/GDP ratio. However, as shown the US has a far higher Debt/GDP ratio for any given OADR level. Let's look at a couple of data points.

• When the OADR is 0.20, both Australia and France have a Debt/GDP ratio of about 0.25. Meanwhile, the US has a Debt/GDP ratio that is nearly 4 times higher at close to 1.00!
• When the OADR is 0.25, both Australia and France have a Debt/GDP ratio of about 0.60 (close to the Maastricht Treaty standard). Meanwhile, the US has a Debt/GDP ratio close to 2 times higher at around 1.2!

The scatter plot on the right focusing on the Median Age -> Government Debt/GDP relationship directionally tells you the same thing as the graph on the left. But, as shown the relationship between Median Age and Debt/GDP is a bit more random. Nevertheless, it is still worthwhile to look at a couple of data points.

• When the Median Age is 32 years old, both Australia and France have a Debt/GDP ratio of 0.25. Meanwhile, the US has a Debt/GDP ratio that is over twice as high at around 0.55!
• When the Median Age is 37 years old, both Australia and France have a Debt/GDP ratio of about 0.60 (close to the Maastricht Treaty standard). Meanwhile, the US has a far higher Debt/GDP ratio of 1.00.

Conclusion regarding the US fiscal condition

As reviewed, demographics aging is very informative regarding the fiscal condition of a country. However, the US fiscal condition is far weaker or far more leveraged than its relatively younger demographics suggest.

The outlook for the US fiscal condition is really poor because:

• Demographics aging will continue for numerous decades; and
• The US Government's fiscal management is incompetent.