Demographic shift presents challenges and opportunities

Small things add up. Or, so our mothers have told us. Be it habits or tastes, our mental maps assume a linear dynamic at work. One plus one equals two.

In financial markets, however — things aren't all so clear. Markets tend to operate in a non-linear fashion. For example, nowadays, many expect inflation to lie low for a while and suddenly explode.

While that law of non-linearity is unknown, we do know that probabilities that govern market events dictate frequent wildly oversized moves in asset prices. However, two of the few places in financial markets where things do add up linearly are on a company's balance sheet, or in a country's macroeconomic indicators. This is particularly so in the national savings rate. That is, if households and private sector firms save on their own, then the aggregate savings rate tends to rise.

All of macroeconomics is governed by a more extensive version of this accounting identity. Savings less investment is equal to current account. In English, this means — if a country saves more than it invests internally, that excess of savings must flow out into the rest of the world. Thus, the nation acquires foreign assets.

In contrast, if the savings are less than the investment, foreigners have to finance that shortfall by acquiring domestic assets. From this simple macroeconomic identity emerges all complications in foreign exchange and trade — such as international flow of capital, relative interest rates and all the political economy tales of intrigue. So, naturally, one must wonder why does one country save more than others do. This is a harder question than one realises. Yet, many argue, demographics is the answer.

Typically, young people tend to save more than older people, as the older generation spends its savings made earlier. As per the life-cycle theory of savings articulated by Modigliani-Brumberg in 1954, it was argued that "population growth and per-capita income growth results in higher national savings rate". As the population grows, the number of savers increases. As economic growth happens, the younger generation tends to be richer and save more than the older generation. While the specifics of the life cycle hypothesis have been challenged by subsequent research, the underlying notion that savings profiles change by generation is something widely acknowledged to be true.

Global trade

It is in this context that the consequences on global trade flows given the demographics of the North Atlantic nations are increasingly discussed. The aging of the population and the slowing down of the economies are even more pressing issues given two facts:

One, this is the first year that the retirement benefits of baby boomers (those born immediately after the Second World War) begins. Two, structural collapses in portions of the US economy (housing, construction etc.,) and political malaise about the right solution (other than printing more money) leaves little hope that a growth turnaround is likely.

On the other hand the emerging markets, with their younger populations and higher growth, have turned out to be net savers in the world. As a result one could argue that the lower interest rates that we have seen in markets in the past two decades were due to the rising savings rate in these nations.

Will this change? According to Goldman Sachs and most demographers, the number of countries likely to save is only going to increase.

The impact of demographics could be such that countries such as Japan and Germany which usually run current-account surpluses could run deficits; while in contrast, India and Turkey — which usually run deficits — could run surpluses.

What this means over the next 20 years is that many of the emerging markets will be likely to continue to finance the developed world's infrastructure development and its level of interest rates domestically.

With an increased flow of capital, one ought not to be surprised that foreign exchange volatility would lead to greater and more frequent financial crises — as the system lurches to and from its equilibrium. More fundamentally, as savers increase — the emerging markets will have to improve regulatory and governance mechanisms. This is the hardest part. In essence, demographic changes are going to induce fierce challenges. Awe-inspiring opportunities are going to arise to redraw the world's economic map.

As I have grown older, whenever I have grumbled about my mother's rising expectations of me, she retorted "Nobody said growing up was easy". Perhaps that is something India, Brazil, and Turkey need to remember as well.

The columnist works for a major European investment bank in New York City. You can follow his tweets at http://twitter.com/ks1729