Today’s Hub Dialogue is with Charles Goodhart, a financial markets professor (emeritus) at the London School of Economics and a former member of the Bank of England’s Monetary Policy Committee, and Manoj Pradhan, who is the founder and chief economist of the macroeconomic research firm Talking Heads Macro. Goodhart and Pradhan are the co-authors of a fascinating book, The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival.
This conversation has been revised and edited for length and clarity.
The demographic reversal
SEAN SPEER: Thank you, Charles and Manoj, for joining me to discuss your timely and thought-provoking book.
There have been a lot of books and academic papers produced in recent years on the consequences of aging demographics in advanced economies like Canada, the U.S., the EU, the UK, and elsewhere. But the demographic reversal in your book also accounts for China’s changing demographics. How are China’s demographics changing? And why are they such an important factor in your story?
CHARLES GOODHART: Well, perhaps I should take the lead speaking not on China, but on more general issues. What happened in the three decades up until 2010 was the largest increase in the availability of workers that the world has ever known. This was partly due to the arrival of China and Eastern Europe into the world’s trading system. It was also due to the fact that there was a huge shift in the birth rate from being very high in the years up to about 1960 to declining very rapidly, indeed, particularly in China with the one-child policy. That enabled women, with many fewer children to look after, to enter the world’s labour force in a much greater amount.
So, the combination of these three factors: globalization—namely, the inclusion of China and Eastern Europe in the world’s trading economy; the very sharp rise in the number of those of working age population involving the fall in the dependency ratio, particularly the number of children; and the increase in the proportion of women working in the labour force, rather than doing housework, led to an unparalleled increase in the availability of workers.
The available workforce, effectively, more than doubled and nearly tripled during those 30 years. There’s never ever been anything like it. Inevitably, when you get a huge rise in the availability of one factor of production, the return to that production—in this case, wages and earnings, declines relatively—while the returns to other factors of production, namely capital and managerial and other human skills, rise equivalently.
That meant that the bargaining power of labour declined incredibly sharply. The number of people in private sector/trade unions, particularly in manufacturing, declined very, very sharply, and that contributed to enormous downwards impetus and pressure on inflation throughout the period.
The demographic conditions changed really quite sharply around the year 2010. Whereas the demographic and globalization factors of the previous three decades were all leading to a beneficial supply shock with a huge increase in labour availability, that is now reversed. And globalization itself is under reverse pressure, with the increasing disagreements between the U.S. and China, and the effect of COVID as well, bringing about a much greater desire to have all the key strategic industries in one’s own economy.
But the momentum of the weakened labour bargaining power was so strong that we didn’t know how long it would be before the downward disinflationary pressure would be reversed and you’d have structural inflationary pressures. But that whole process has been dramatically shortened by the arrival of COVID, which has led to the kind of shortages of labour that we thought would occur, but possibly maybe a decade or half a decade beyond, but is occurring much more quickly in many countries, notably in the U.S. and U.K. and of course, particularly in China. I’ll hand it over to Manoj to reply to your queries on China.
MANOJ PRADHAN: Thanks, Charles. And thanks, Sean, for having us here.
On China, I’ll make three points that really tell you how incredibly important the developments in China were. The first one, just to give you a sense of the impact, I’m going to refer to a paper that was written by two Federal Reserve researchers, Pierce and Schott, entitled, “The Surprisingly Swift Decline of Manufacturing Employment,” which kind of says it all.
The argument that they made, going through micro-economic data, was that after China was given Most-Favored-Nation status by the U.S. Congress in 2000, what you saw was a very, very, very sharp decline in manufacturing employment in those activities that have been protected by tariffs and were very labour intensive. American manufacturing output didn’t fall much because productivity went up. The decline in employment that we saw was partly picked up in the construction sector.
The second point I would make is that China’s integration—not just the sheer size of its labour force, but the integration of China’s labor force into the global manufacturing process—effectively meant that China’s set the equilibrium wage for manufacturing around the world, and everyone else saw a very gradual disinflation in real wage growth, to try and catch down to China’s level of wages. If you couldn’t compete with China, you would offshore production to China. As a result, the Chinese economy was obviously under relentless pressure to see exchange rate appreciation.
But Chinese authorities broke what economists called the “Impossible Trinity”, by limiting capital inflows. That allowed them to set the exchange rate at a very competitive level, and also to regain monetary independence to set interest rates at levels that would encourage investment, and the attractive exchange rate allowed that investment to be geared towards export production.
Now, what’s changed is that over the last 30 or 35 years, China’s disinflationary impulse has been so strong that most policymakers in the West have taken for granted the fact that inflation simply will not rise, even if growth comes back or the output gap is positive. In other words, what economists call the “Phillips Curve” is presumed to be dead. We think that’s an exaggeration.
China’s disinflationary impact, as Charles described very eloquently, is probably behind us now. The fiscal and monetary policy impulse in advanced economies is currently so strong that we’re likely to see inflation rising. In fact, if you look over 2021, the Chinese economy was the one economy that was slowing, while every other economy in the world was growing, which means demand was collectively coming at us from many different places in the advanced and emerging market economies. But the factory floor of the global economy, which is China, was seeing strains in labour and supply chains, and that led us to the supply-demand imbalance that has created sky-high inflation.
So, if China continues to have a demographic slowdown where the number of workers available continues to slow down sharply, then the supply constraints and the labour side of the equation is going to become much stronger, and most economies will find that inflation is actually going to be more persistent than they had bargained for.
The future of productivity
SEAN SPEER: Let me just pick up on something that Charles said. The book observes that in a world of shrinking workforces, higher productivity per worker will be key to drive growth and raise living standards. Yet, in the story of recent decades, the period in which you broadly cover, we have seen sluggish productivity across advanced economies. What do you think has led to our poor productivity performance? And what can we do to boost productivity in the world of labour scarcity?
CHARLES GOODHART: We’re quite optimistic about the future of productivity. One reason why productivity growth in the advanced economies was so slow was that manufacturing, where you tend to see productivity increases most obviously, shifted over to China. And productivity in China rose very sharply indeed.
Manufacturing firms didn’t need to increase productivity at home because real wages were held down by China for the reasons that Manoj very clearly set out. They were making massive product profits by offshoring to China. As the spat between China and the United States probably intensifies, manufacturing firms cannot rely on simply importing manufactured goods from the world’s workshop in China. What will happen is the manufacturers will have to offset the rising unit labour costs that will otherwise occur by increasing investment and increasing productivity at home. So, we think that output per worker is going to increase much faster over the next few decades than it has in previous decades.
The problem is that they’re just going to be such a fast break in the number of workers. So, the rise of productivity, which we expect and look forward to, is not going to be enough to offset the decline in the number of workers, so that overall, aggregate growth in most of our economies is going to remain at very low levels, or even slow down further.
MANOJ PRADHAN: The manufacturing sector and the services sector compete for workers. Over a period of time, I think what is going to be a relentless story is the demand for people who are absorbed into the service sector looking after the elderly, and I don’t mean just looking after the elderly physically. There are going to be so many people filling up the ranks of the aging that we need all the help that we can get from labour.
We’re likely to see inflation rising.
Most people are worried about technology destroying jobs. Charles and I disagree. We think it’s something that we need as much as we can get. Some of the jobs that are being lost to technology in the manufacturing sector, or even part of the services sector due to automation and AI, will release labour to other parts of the economy that need it for tasks that cannot be automated.
The key difference is the following: when we think about the role of labour in the manufacturing sector, they are an input into the production process—that is, they produce a good that will be consumed by someone else. When that same person goes to work in the services sector, and particularly looking after the elderly, he or she produces a consumption good—that is, that consumption good will be consumed by the elderly, but nothing else will come out of it. Unlike the young, the elderly will not be able to go back into the labour force and produce something else to pay for this consumption good.
So, workers involved in caring for the elderly are “socially productive” because that kind of social safety net is required in our societies, but not economically productive. So, the concerns around technology that people have and the way they think it stands against our thesis is actually far more of a complementary story, from our perspective.
Declining labour
SEAN SPEER: Your responses outline how the decline in the supply of labour will cause firms to invest in productivity-enhancing technologies in Canada, the U.S., the EU, the UK, and other advanced economies. What about China? China has, for the past several decades, relied on a comparative advantage in relatively cheap labour. As it faces demographic changes, how will China adjust such that it can find new comparative advantages to compete in the global economy?
MANOJ PRADHAN: China was in an incredibly complacent frame of mind until about 2018. Policymakers expected consumption-led growth to deliver high and sustainable growth. In our book, we’ve argued against this perspective.
The increase in real wages that we saw in China was a result of the dramatic growth that they had and the investment that was generated through the monetary policy stimulus that I mentioned earlier. If we think China’s manufacturing story is slowing down, which it has, and if we think China’s property story is under significant stress, which has come under increasing focus recently, then the demand for labour is much lower. And that means the real wage within China cannot grow aggressively.
Under this scenario, economically speaking, consumption growth would remain very low, because wage growth could not sustain itself at high levels. The overall growth rate would probably have stumbled to somewhere around two to three percent over a five-year period.
In 2018, I think the trade war that President Trump launched inadvertently did China a massive favour. Until then, they thought the capital allocation towards the consumption side would happen seamlessly. Now, the restraints on their exports have forced China to focus resources on parts of the economy that really would be the most productive. Along with that came a renewed focus on how they could finance that growth.
So, when you look at the path that China has taken fighting against property, trying to rebuild the social contract that the government has with the people by its common prosperity drive, and its greater focus on technology, you can see a renewed strategy for Chinese growth. Effectively, what they’re trying to do is they’re trying to have a “barbell model”. The barbell model consists of what we would have called back in the past the Commanding Heights, but we would now have to call them the New Commanding Heights because they include all the key economic infrastructure including service provision and new technologies, such as new energy vehicles and other green technologies that move away from coal-fired technologies. This is something that they have just embarked upon within the last few years. I think it’s still too early to say whether they will succeed or not, but the focus at least is something that is a very welcome one at this point.
CHARLES GOODHART: I would just add that our book is more widely read and more popular in China than almost anywhere else.
SEAN SPEER: Charles, let me ask you a question. One of the insights of the book, which is intuitive, yet sort of profound, is that the trends that you described have led to a decline in global inequality on one hand, but a rise in inequality within advanced economies. You anticipate that some of these changes reflected in the great demographic reversal will lead to higher wage growth in advanced economies, and in turn declining inequality at home. Can you please elaborate on how these trends will manifest themselves with respect to inequality?
CHARLES GOODHART: Yes, as Manoj said earlier, real wages have been held down really quite sharply, and the returns to capital have been great. Asset prices over the last 30 years have been generally on a very strong bull market rising to remarkably high levels. This is going to reverse as the increased inflation has already shown. Nominal interest rates are on the way up now, and the fear is that they may be raised so fast that you could get a financial collapse and the possibility of a severe recession, driven by falling asset prices and rising nominal interest rates.
If central banks get too worried about their credibility and their failure to achieve the inflation target and they raise interest rates very sharply, we could be in a really rather tough time. It’s going to be extraordinarily difficult for central banks over the next few years to steer apart between allowing inflation to get entrenched on the one hand, and raising interest rates so high, that we get financial severe difficulties on the other hand.
It’s going to be extraordinarily difficult for central banks over the next few years.
So, the picture is widening in which real wages will now start rising faster, and the returns to capital will start rising a great deal slower, and for a quite number of years, they may fall. That is going to reverse the within-country inequality, which has been such an unfortunate side effect of these trends over the last 30 years. And with any luck, it will reduce the degree of polarization of political views, often described as populism, that we’ve had in recent years. The rich will become less rich, and the larger number of those in the workforce will now become better off. And that, again, is one of the more optimistic side effects of the general trends that we see developing, and one of the key points, I think, of our book is don’t believe that the future is going to be like the past. It’s not. It’s going to be very, very different in many ways.
Globalization
SEAN SPEER: In your last answer, you both spoke to the potential political economy effects of some of these trends. The book also talks about the potential impact on globalization itself. Do you want to conclude with some insights about how this mix of demographic and economic changes that you’re anticipating may affect globalization, which has been such a crucial part of the way we think about political economy for the past 30 years or so?
CHARLES GOODHART: One of the features of the relative decline in real wages, compared with the increase in the returns to capital to the rich, has been growing agitation on the part of many of those in the working class that the political elites have ignored. These working-class grievances aren’t without some basis. Many have blamed their adverse developments on immigration and on competition from low-wage countries abroad. There’s been a tendency towards, what you might describe, as nativism and trying to do everything at home. That means that I think that the globalization paradigm, including the freedom to move capital freely, has been under severe threat.
Another feature is that although the decline in the working-age population has been and will continue to be in the coming decades, remarkable in the West and in Asia, there’s is one continent where this is not at all true, and that continent is Africa. I was particularly struck by a recent comment by Larry Summers that in about 30 years, a quarter of the world’s population will be in Africa. A key development, which has not yet really come into people’s thinking, is that how the world deals with Africa over the next 20 to 50 years is going to be absolutely critical in the world’s development. We have to worry about Africa a great deal more than we have in past decades.
MANOJ PRADHAN: I would only add a slightly different take on your question, Sean. So, your question was how does all of this impinge upon globalization? And I think it’s very clear from Charles’ answer that we’ve made a substantial retreat from globalization especially compared to the kind of expansive globalization that we had before the great financial crisis. The one thing I did want to bring back into the picture is that the pre-financial crisis era of globalization allowed firms that really couldn’t match the cost-effectiveness of China to start manufacturing there and take advantage of its low costs. Now with the current geopolitics, many firms, either for supply chains, insurance purposes, or because of geopolitical outcry, feel compelled to bring production offshore.
On a local basis in the United States, what that might tell us is that output per worker is going to rise. Typically speaking, when we’ve seen output per worker rise, we should expect lower inflation.
If it’s mainly driven by anti-globalization sentiment, it implies that if a firm could ideally locate its production facilities anywhere in the world, without any constraint, it would still probably want to do so in China. The fact that some of it is coming back to the United States or to these advanced economies is because of non-economic reasons. And so, even if the output per hour mathematically goes up, from a company’s point of view, this decision would be suboptimal. They will be compelled to share some of it with workers, of course, because there’s going to be a shorter number of them.
That can sustain higher real wage growth, but also, they will be compelled to pass some of the higher overall cost of such suboptimal production onto consumers. And that will mean that the disinflationary impulse that we should expect from productivity is much lower in a de-globalized world than it would have been in a world that was abundantly globalized.
SEAN SPEER: Well, gentlemen, this has just been a fascinating conversation. The book, of course, is The Great Demographic Reversal: Aging Societies, Waning inequality, and an Inflation Revival. As we look beyond the immediacy of our challenges and think about the big structural trends that will shape our economies, our societies, and the global economy, this has been a master class in framing these questions. Congratulations on the book and thank you so much for sharing your time and insights today.
CHARLES GOODHART: It has been a pleasure. Thank you.
MANOJ PRADHAN: Thanks for having us, Sean.
