Finance: Research, Policy and Anecdotes

Demography, inequality and inflation

Every year, the Florence School of Banking and Finance organises an Executive Seminar. This year’s (as last year’s) edition was shortened and virtual, but nevertheless fascinating.  Many economists (including this one) see the current burst of inflation as temporary, result of market imbalances, of repressed consumption and forced savings during the pandemic and (maybe just maybe) generous support payments during the pandemic).  Charles Goodhart and Manoj Pradhan disagree with this assessment, though focusing more on the medium- and long-term, arguing that demographic trends will lead to a long-term increase in inflation.  They lay out their argument in the book “The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival” and presented a summary last Thursday in a webinar. Due to the ageing of societies across the globe, the share of working population has been decreasing and will continue to do so. Previous positive shocks the global working population (entry of women into the labour force in the second half of the 20th century and China’s entry into the world economy towards the end of the 20th century) had positively contributed to the dampening of inflation in the late 20th century – no such shock is on the horizon right now. And while the working population in some parts of the work (especially India and Africa) is still increasing, political constraints prevent them from reallocating where they would be needed most – in the ageing societies of Europe.  A higher share of old population in turn requires higher government spending, both for pensions (unless the retirement age is pushed significantly than it is today) and due to higher medical expenses.  The question on how to finance these expenditures is a politically sensitive one – higher taxes on wealth (which would hit primarily the older generation) is politically hard to implement (the triple lock in the UK, where state pension increases each year in line with the rising cost of living seen in the Consumer Prices Index (CPI) measure of inflation, increasing average wages, or 2.5%, whichever is highest, will increase pensions by over 8% this year and shows the political power of the older generations), and increasing income taxes on the working population could be growth dampening. 


Remains the inflation tax and that is where Charles and Manoj see the inflationary pressures coming from. While the Covid crisis might have made these trends worse, the increase in debt due to the pandemic might ultimately turn out to be only a blip in the longer-term trends lines.  The higher debt burden (and the deteriorating savings-investment balance) will tend to increase the long-run equilibrium interest rate (r*), increasing pressure on central bank independence. But even though central banks will feel compelled to keep short-term interest rates low, long-term rates will rise, with a steepening yield curve as consequence.  I would add that this could play out even more aggressively in the euro area with its variation in demographic structure and debt-to-GDP ratios. Overall, a rather scary picture.