Welcome To The Menagerie III

Well I'm back from my guest blogging stint at New Economist. Afoe is also temporarily down for maintenace repairs, so poor readers I have no excuse to not come home and carry on with this unusual series of posts.

Right now I am steadily working my way through the papers of Ralph Bryant and Warren McKibbin trying to see what can be learnt from the trajectory they have followed.

The first significant paper they seem to have written in the field of demographic consequences seems to have been "Issues in Modeling the Global Dimensions of Demographic Change" (1998).

The paper is a kind of state of the art summary - back in 1998. It is really a write-up of feedback obtained at workshops held in Washington, Paris and Tokyo during July 1998, and as the preliminary blurb says:

"As a first step in developing a better framework for dealing with global demographic change, this paper surveys the areas in which we need to improve existing global analytical frameworks to deal with the range of important policy issues that will emerge as a part of the demographic shifts. The paper attempts to summarize what is now known, identifies areas where important unresolved debates still exist, and explores theoretical and empirical issues on which more research needs to be undertaken."

As the authors say:

"The goal of the paper is to take stock of what the economics profession knows about modeling the macroeconomic consequences of population aging. We focus particular attention on the likely consequences for changes in saving-investment-current-account balances and in asset prices -- for individual nations, and for the world economy as a whole."


Speaking of the ambition of their work the authors state:

"The objectives of this project, with its emphasis on the cross-border consequences of demographic change, cannot be achieved without use of one or another multi-country, generalequilibrium macroeconomic model."

However:

The most notable inadequacy in existing multi-country macro economic models is their failure explicitly to incorporate the effects of demographic changes. As preconditions for achieving the major objectives of the project, therefore, researchers working with the multicountry models must improve their equation specifications in at least three respects. An improved analysis is required of the effects of demographic changes on:

(1) consumption (including possibly patterns of consumption across different goods and services), saving, and wealth accumulation, with appropriate allowance for the
openness of national economies;

(2) the production/supply sides of national economies, again with appropriate allowance for openness; and

(3) expenditures, transfers, and revenues in government budgets.


As they also note:

"Most industrial countries have experienced two important behavioral trends. Labor force participation rates for male workers, especially in the last years of normal working life, have been declining. And labor force participation rates for female workers have been secularly rising. The first of these behavioral trends exacerbates the adverse effects of population aging on the effective labor force. The second has worked in an offsetting direction."

As both James Hamilton (Econbrowser) and Dave Altig (MacroBlog) have recently indicated these kinds of demographically associated behavioural trends may be pretty much at the heart of recent US labour market phenomena - this however is marginal to my present preoccupations.

Perhaps it is important to note that all the above sets down a pretty substantial agenda for macro economics, so in this sense it could possibly be regarded as the starting point.

The paper also contains this idea:

"Population aging will occur at differing paces and with differing degrees of intensity in the industrialized countries of the world."

So it is the relatively different pace of ageing which needs to be part of our focus. One thing is becoming clearer. Actually, if you look at it from this point of view, the whole demographic transition is an *ageing* one, after the initial kick-start. What do I mean? Well, initially you get a substantial rise in the birth rate and fall in infant mortality, which presumeably shoots the median age right down to all-time historic lows, and from there on, as they say, it's uphill all the way. Japan is currently just over 42 years old, and rising, and we don't know where the limit is.

Of course, this clears up one other key relation: the important thing is surely how rapidly we move upwards through the ages our active capacities in relation to the rate of increase in median age.

The Lifetime Model

There is another thread worth picking up in this paper, and that is that of the assesment of the work of Friedman and Modigliani in relation to savings and consumption behaviour over the life-cycle:

During the July 1998 workshop discussions for this project, a large part of the dialogue was devoted to analytical methods for studying the consequences of demographic changes for consumption, saving, and wealth accumulation. Given the wide variety of analytical views held in the profession, this area is one of a few central topics on which substantial further research is warranted.

"At a very general level, since the work of Modigliani-Brumberg (1954, 1979) and Friedman (1957), economists have accepted in broad terms the idea that many households will wish to smooth their consumption across time."

I think we get off to a bad start here, and 'll explain why. I don't think the best way to go about this is to specualate about what households (or even individuals) may wish, or not wish to do (the explanation), where we need to be is with the outcomes, what the data can tell us about what they actually do. I stress this particularly since I think far too many macroeconomists spend their time worrying about the implications of their work for the microeconomic foundations of modern macro, and I tyhink this is an overly 'theorised' approach. We need to have models of the macro economy which tell us something aout the important things going on, and one way to achieve this may be to 'black box' the micro issues. This is what I am doing. I am simply agnostic in this regard.I simply don't have the time, and this seems to me to be the 'cleanest cut'.All of this becomes important when you look at the continuing sentence:

"The degree of this intertemporal smoothing and the main factors driving it, however, continue to be much in dispute."


This is something you will see repeated on numerous occassions, it has become part of the 'economists folk culture'. But actually how valid is it? And if it isn't valid, aren't most macro theorists, when they base themselves on the view, really puttting the telescope over Nelson's bad eye?

"One set of issues concerns the manner in and degree to which households or individuals voluntarily want to act as intertemporal smoothers"

This is the set of issues that I am suggesting we should neatly side-step.

"A second set pertains to whether constraints external to the household inhibit or prevent agents from acting as intertemporal smoothers."

This looks much more promising.

"Explicit life-cycle approaches hypothesize that consumers save little in their early years, save most in their middle-to-late working years, and then spend down their wealth accumulation after retirement."

Now this is not a statement about intentions. It is one about outcomes. This can be tested. This is the way to go.But somehow it doesn't seem quite right.

Basically, following the work of swedish demographer Bo Malmberg, and drawing on Dvaid Bloom and others, we can break down the demographic transition as it affects age structure into stages.

First of all there is a child dominated society (Niger, Bangladesh, Nigeria etc) where the burden of having so many non-productive children normally produces negative saving and indebtedness (especially at the state finance level).

Then comes the young adult stage, where saving predominates over investment, China is, of course, the classic example of that right now. Then you have the mature adult society - with one more time indebtedness and negative saving, but this time producing consumer driven booms - here we might think about the UK and the US.

Finally old age arrives, and once more people begin to save appreciable portions of their income, and consumer demand is flat, or even falling slightly. I say finally, but maybe I spoke too soon, since we still don't really know what comes next. On the standard version of the life cycle theory people should start at some point to draw down their savings, but to date there is little evidence of this (and this is one of the objections that is being raised to the life cycle theory). However, if we look at things in terms of Ricardian equivalence, where we take the aggregate of private and state borrowing into account, then clearly looking at Germany, Italy and Japan there is growing evidence of some kind of symmetry with the debt problems of the child dominated societies, certainly in terms of the move towards unsustainable government debt dynamics. At the same time we may yet see the savings 'drawdown' predicted by the young Modigliani, we need to wait and see.

Anyway this highlights two issues: the mature adult and the old age societies, maybe early versions of the life cycle model put this much too simplistically.


Some researchers interpret the empirical evidence as broadly supporting the lifecycle view, including the hypothesis that consumers are patient enough to begin saving for their retirement early in their working lifetimes. Examples of researchers sympathetic to the life-cycleview include Attanasio-Browning (1995) and Meredith (1995). Other researchers, however, read the empirical evidence as providing only weak support for the life-cycle view of saving and instead supporting the hypothesis that consumers save and accumulate wealth primarily to insulate consumption against uncertainty about fluctuations in income. In this latter view, the saving for retirement motive is much less important than the precautionary saving for uncertainty motive. (Precautionary saving for uncertainty leads to the accumulation of "buffer-stock" assets.)

As I keep highlighting the preoccupying detail here is we keep talking about *motives*, when what we should be looking at are outcomes.


"Several participants in the July workshops emphasized the point that the life-cycle hypothesis, as studied in the context of microeconomic panel data, appears unable to account for the most prominent observed changes in several countries' saving behavior. For example, the lifecycle hypothesis does not do a good job of explaining the pronounced decline in the saving ratio in the United States in the last several decades. Nor can it explain the pronounced increases in saving ratios in several Asian countries (such as China, Indonesia, South Korea, Singapore, and Thailand)."

Well, I'm sorry gentlemen, as I am explaining, I think a version of the life cycle model, suitably calibrated with the data, can fit these developments quite well.

The US has, remember experienced an immigration induced demographic shock since the mid 80s which has transformed its age structure, and obviously the net impact (at the aggregate level) can be negative for saving. The isssue with the asian tigers needs less comment, as I think Bloom and Williamson's findings have now achieved a widespread acceptance.

"Most of the households in the U.S. economy seem to have cut their saving at the same time, and most of the households in the relevant Asian economies seem to have increased their saving at the same time."

Of course understanding this seems to depend on understanding the meaning of the term 'most'. These movements are perfectly compatible with substantial demographic shifts. There is also the issue of individual vs household, but this can wait for another day.

"Yet the microeconomic analyses of saving behavior are not throwing up a consensus explanation for these time trends. In particular, the demographic components of the simpler versions of the life-cycle hypothesis are certainly not providing the explanation. "

Exactly, the simpler versions of the life cycle hypothesis need modifying.


Angus Deaton in a recent and highly readable assesment of the Modigliani thesis has this to say:

In these extreme precautionary or “liquidity constrained” accounts of saving, consumption is smoothed, not over the whole life-cycle, but over much shorted periods of a few years at a time, see again Carroll (1997) and Deaton (1991). In the literature, this is often referred to as “highfrequency” smoothing of income, as opposed to the “low frequency” or “life-cycle frequency” smoothing that was postulated by Modigliani and Brumberg.

These results are not inconsistent with Modigliani’s argument about precautionary saving for (possibly the majority of) consumers who, under the original life-cycle model, wish to save, not borrow. These will be people who are sufficiently patient so as to be happy to postpone their consumption, or who do not expect much income growth in the future. Indeed, it is possible to reconcile the traditional and the new view by noting that it is the youngest families who are likely to want to borrow, but either cannot or are too prudent to do so, and are therefore more or less constrained by their current earnings, while those in middle-age behave in the traditional lifecycle way. That such a formulation is consistent both with expected utility maximization and with the survey data has been shown in an important paper by Pierre-Olivier Gourinchas and Jonathan Parker (2002).


OK, now back to the Bryant and McKibbin paper:

"A further difference of view in the saving-consumption literature concerns agents that in practice may not be able to borrow and lend freely as the simplified intertemporal smoothing models presume they can. The theoretical treatment and empirical importance of such liquidity constrained households is controversial."

Naturally the paper notes that "It seems natural to suppose that large changes in the demographic structure of populations will have significant effects on consumption and saving. The effects should be larger, the more pervasive are life-cycle elements in the behavior determining saving."

However:

"Most aggregative macroeconomic models have failed to allow for such changes in the demographic structure of the population. The seminal contributions to growth theory in the 1950s and 1960s abstracted from such demographic factors."

So this is a clue to what has happened.

In effect, those models contained no children and no elderly, with the result that a faster (steady-state) rate of growth of population caused the saving rate unambiguously to rise in response to higher requirements for investment and a higher capital stock. Tobin (1967) developed a simulation model differentiating workers from retirees (but still without children). Tobin's model also predicted that faster population growth would raise the private saving rate, because the faster growth caused the population distribution to become younger (more working, saving households relative to retirees who were older and dissaving).Even as theoretical growth models matured, most empirical macro models still abstracted from shifts in the demographic composition of the population. This omission persisted despite the major emphasis in consumption theory of life-cycle considerations in the microeconomic behavior of households.

Now comes the clue:

A strand in the literature on development economics was sensitive to these issues; see, for example, Coale-Hoover (1958), Mason (1987, 1988), and Taylor-Williamson (1994). The builders of empirical macroeconomic models, however, did not try to incorporate this work. To be sure, the development-economics literature for the most part did not directly address the details of how to adapt the consumption-wealth specifications in general-equilibrium macro models. The development-economics literature on population dynamics and saving is reviewed in recent papers by Higgins-Williamson (1997) and Bloom-Williamson (1997). Deaton-Paxson (1997, 1998, 1998) and Paxson (1996) are recent studies.

And now we get to the rub:

"When specifying the consumption-saving-wealth relationships in macroeconomic models,
issues of aggregation are very important. In particular, the aggregation issues are central for getting an adequate macro specification of the demographic influences."

However:

"Macro models built up from a micro theory positing a single representative agent are not easily adapted so as to incorporate demographic changes."

Oh. And why would that be?

"By definition, changes in the demographic composition of the population require analysis to acknowledge the heterogeneity of agents -- at the very least heterogeneity in age."

Ah yes. Quite.

As they then go on to explain, there is another class of models, the overlapping generations one, which attempts to grapple directly with one or more dimensions of heterogeneity across agents.

So the OG models could be more promising, but, there are no free lunches. They are much more difficult to construct and work with:

An explicit multi-cohort approach, at least seen from some perspectives, appears more rigorous theoretically. But such an approach may also be more difficult and demanding, and will probably take much longer to advance to the stage where the models can deliver interesting empirical conclusions. The requirements of a multi-cohort specification are of course especially demanding in a model with numerous separate national economies and national currencies. Another possible disadvantage of the multi-cohort specification is that it might, if calibrated to partial-equilibrium relationships derived from micro-level evidence, deliver misleading inferences about aggregative macroeconomic relationships.

The authors however remain agnostic:

As of the time this paper is written, the economics profession has no sound basis for judging whether an explicit, multi-cohort approach will over the longer run provide the most reliable empirical conclusions and projections about macroeconomic behavior.

As they suggest, despite the limitations, adapting existing models - like the IMF Staff's MULTIMOD - may prove to be the most direct and effective way of getting at some orientative results. Well, this has been long. It has certainly been useful for me. If you have arrived this far I hope it has been for you too. I'm afraid there *is* more to come.