Known Unknowns in Global Economics

November, 2015

A decade ago, U.S. Defense Secretary Donald Rumsfeld ruminated about the uncertainties of life and how little we know about our wider environment. His comments were not original with him, but they did popularize the categories of what we think we know, what we are aware of but are ignorant of its outline and details, and what we don’t even suspect that is lying out there: 1) the knowns, 2) the known unknowns and 3) the unknown unknowns.

A lot of people made fun of Rumsfeld and his categories, but they have entered the popular lexicon and he even used a variation as the title of his memoirs. I had run across the same classification system many years before and it has proven useful to me. I am pretty sure the ancient Babylonians and Greeks used it.

We are a global society slowly beginning to explore a couple of ‘known unknowns’ that need to be managed right as we start to experience their effects.* These are population decline and price deflation. By and large, the development of modern economies over the past 500 years has come with a continual increase in population and our general economic thinking has been predicated on an assumption that the population of a society and therefore demand for goods and services will be potentially larger tomorrow than today. What if that assumption is beginning to be incorrect?

Second, at least since the Great Depression, there has been a presumption that one of the major challenges to economic management has been the need to control inflation. In the early 1980s, when inflationary pressures began to recede under the installation of high interest rates, many commentators wished for the halcyon days that would come when price stability (read: zero inflation) was achieved. Well, here we are, at least in some societies, and close to it in many more.

If you look at reliable projections of population for the major societies in the world, say, the US, the EU, Japan, China and India, with the exception of the last in this list, populations will start to decline from now (Japan) until 2050 and will keep doing so thereafter. These projections are inexorable without very heavy immigration from other countries with ‘better’ demographics or intolerable governance.

We do not know how to deal with this phenomenon, but we are learning a bit from Japan about it. Japan’s population has begun to decline recently after a couple of decades of stagnation. Its labor force has remained steady in size only because of poor pensions, which force many retirees back into the labor market. The labor force could grow if there weren’t cultural constraints against greater female participation and against immigration. The present government has said it wants to change the first of these, but it is doubtful that exhortation will accomplish a lot before the size of the decline in Japan’s labor force overtakes these wishes.

Further, all of the experiments in places like Russia and Canada and Sweden and elsewhere to provide incentives for citizens to have more children have proven, at best, to lead to minor changes in birthrates, but nothing near a rate that would lead to population stability. Note that the decision to have children in the more developed countries is normally one made by both prospective parents. Policymakers have not got their heads around this yet.

The ‘known unknown’ in this situation is how does a society maintain any kind of economic growth when one of the two main drivers, population/labor force and productivity, does not exist? So far, the Japanese have shown us that they haven’t a clue, but are vigorously pushing all the available policy buttons. Their economy has been more or less flat for two decades and more. Maybe that is success …

The second problem is tied to the first, but has its own dynamic. As noted above, coping with inflation has been a concern for decades now. Too much money chasing too few ‘goods’. Run government surpluses in good times and deficits in bad. Keep the value of the currency stable. The stress was always on achieving and maintaining stability in the face of upward pressures on prices and wages.

Yet, today, if we return to Japan for a moment, it has been practicing a massive QE, or quantitative expansion of its money supply, for a number of years, really without much effect on the price levels in the country. QE ought to be inflationary, since it pumps a lot more money into the economy.

Let’s pretend that it is inflationary. Then we have to look at why the US, which did much the same thing after 2008, did not have a lot of inflation. In this case, it appears that a lot of the excess cash produced by the Federal Reserve found its way out of the country and into loans or purchases by foreigners. This has not been the case in Japan, where the excess cash has led to a decline of the yen relative to most countries, something that also ought to be inflationary. But not much happened in Japan price-wise either. The implication is that the Japanese QE has only succeeded in keeping deflation at bay. Maybe that is success as well….

Deflation comes from a lack of demand, with prices dropping until the market is cleared of whatever is on offer. If you have a society where there is an increasing number of pensioners, who outstrip the number of new, young entrants into the workforce, then you will get a decrease in demand. This is because retirement for most people brings with it a decrease in income that can equal, say for instance, a 50% drop. Part of this leads to lower spending and part may be made up by savings. We can include public and private pensions in the 50% that was maintained. Savings rates in the country would drop and demand would decline as well, which is what we have seen in Japan.

There is a second effect when we get to population decline, but first let’s explore the difference between labor force decline and that of population. In places like Canada and Japan, people normally retire in their early 60s, say 62, and they normally die around 80. Therefore, they spend 18 years living on reduced incomes and reduced demand.

Labour force decline puts a cap on how much a society can produce, unless non-participants are encouraged into working or there is adequate immigration. Otherwise, the job of increasing output has to rely on productivity increases. In both instances, people and productivity, there are a number of cultural constraints that work against this neat, logical solution.

Population decline puts a constraint on demand as well as investment. First, less people means a smaller market. Second, it means that investment calculations are upset, in that adding capacity to a shrinking market is an illogical act unless the investor assumes this new investment will drive somebody else completely out of the market. A growing market might be able to absorb new capacity; a shrinking market is a nasty exercise. At any given time there is more capacity than needed, there is no hope that a rising number of consumers will buy their way into a national recovery from recession, there is no prospect for gains on savings and there is no government, save possibly Japan, that has gone thorough the process of the initial denial of this reality towards a policy set that allows us to manage such a condition.

That being said, there are some possibilities for successful management, once we get used to this coming new reality. It will become an increasingly widespread condition and this will encourage innovation in economic management, but right now the economic effects of population decline and deflation are terra incognita. We know it is there, but like the old mapmakers, we don’t know much about it.

Let’s speculate on what might contribute to a more optimistic future. Like the old mapmakers, perhaps we can populate the known unknown ‘lands’ of the future with the odd fair maiden, dragon and golden mountain or two …  in another column.

 Copyright Jim McNiven 2015

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Jim McNiven’s latest book is The Yankee Road: Tracing the Journey of the New England Tribe that Created Modern

Jim McNiven

James McNiven has a PhD from the University of Michigan. He has written widely on public policy and economic development issues and is the co-author of three books. His most recent research has been about the relationship of demographic changes to Canadian regional economic development. He also has an interest in American business history and continues to teach at Dalhousie on a part-time basis.






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