Saturday, June 13, 2009

The Clock Is Ticking Away Under Latvia

As the European Commision and the IMF conduct their latest post-Keynesian "social and economic experiment" in Latvia to see whether an economy which is contracting at an annual rate of 18% under the weight of debt deflation can achieve growth through the weight of fiscal cuts alone - a process which is today glorified with the name of "internal devaluation" but which in the 1930s was simply called what it is: wage and price deflation - a new problem looms its head. What will the long run consequence be for Latvia's already fragile demographic dynamic? The question I am simply asking here is whether short term decision taking - on the part of potential Latvian parents - may not result in further birth postponement, such that impact of the crisis is only a further deterioration in long run population dynamics, and hence, in potential economic performance?

But before we go into the nitty gritty of all this, lets just take a quick look at two charts.

Structurally, they look quite similar don't they? They are both output charts, showing year on year changes in production. The second is a chart for industrial produce, and the second is a chart for children. Strange they should look so similar, isn't it? Or is it? Here we will go into some attempts at providing a theoretical interpretation of what is happening, then, at the end of the post we will take a brief look at what conclusions may be drawn from what is happening.

Theoretical Background

Basically there are two key ideas that you need to get straight here, one of these is Wolfgang Lutz's Low Fertility Trap hypothesis, and the other is Richard Easterlin's cohort size driven relative income hypothesis. You can find a nice summary of Wolfgang Lutz's low fertility trap hypothesis in this post by Claus Vistesen. Essentially there are three basic components to this hypothesis as shown in this diagram which Lutz himself prepared for a presentation:

As Lutz says the key idea is that once fertility falls below a certain level (and even in the event that the hypothesis proved to be well founded this level could only be determined empirically, on the basis of actual experience) a self-reinforcing demographic regime may be established from which it is hard to escape, in the sense of raising fertility back up towards replacement levels. The cut-off point which Lutz et al start from is 1.5 (and in this they take their lead from a proposal by Peter Macdonald in this paper ). This figure does seem to have some coherence in terms of actual experience to date, since with the exception of Denmark - which did briefly fall under 1.5 tfr in the 1990s - no country seems to have gone below this and come, and stayed, back up again.

Now Lutz identifies three potential self reinforcing processes - population momentum, ideational processes, and economic factors - but in this post I want to focus on one of these, the economic one. The explanatory mechanisms we are offered are full of self-reinforcing feedback processes, as can be seen from the diagram below (incidentally please click over the image for better viewing):

Based on the work which Claus and I have been doing on the Life Cycle Model of consumption and savings in the context of rising median ages (see, for example, this post)I think we may well have come up with just some of these.

Essentially the argument, as it is presented here, is that as median ages rise beyond a certain point - 42/43 let's say - the structural characteristics of the economy change. While younger economies - let's say with median ages in the 35 - 39 range - are driven by large scale borrowing (on aggregate), domestic consumption surges, and, of course imports and current account deficits to match the domestic savings weaknesses, the more elderly ones can exhibit higher relative savings levels (Japan, German, Italy, Finland, possibly Switzerland), can no longer rely on domestic consumption to anything like the same extent, and increasingly come to depend on export growth for GDP growth.

Now, of course, this produces a mechanism whereby four things happen:

1) In order to compete for exports these economies have a permanent pressure on their tradeable sectors, whereby outsourcing is continuous and ongoing, wages are continuously compressed, and structural reform is permanent. Since the very export dependence is only further reinforced by the continuing process of change in the population pyramid (ie domestic demand never "recovers" as such) this is all self-reinforcing. That is the more time passes the more there is downward pressure on the wages of young people.

2) Due to the comparatively lacklustre economic growth performance there is a constant shortfall in the tax income necessary to guarantee existing welfare and pension commitments. This shortfall is produced by the low levels of trend growth (think Italy, Germany and Japan) which you can generate exclusively on the basis of export growth. Since the changing pyramid structure (here is another part of the feedback loop) means that an increasing part of the voting population comes to be over 50, the tendency, as we are in fact seeing, is to attempt to maintain welfare commitments by increasing the tax burden, which affects the consumption and earning possibilities of the young directly.

3) Migration factors. The general lack of growth in the economy, and the tendency towards increase retirement ages and higher participation rates at the older ages, all mean that there is a relative lack of well paying jobs at the entry level, a phenomenon which makes outward migration an increasingly attractive proposition for educated young people (again, as we are seeing in Germany and in Italy). This out-migration once more feeds back into the structural evolution of the population pyramid. If the out migration is in part compensated for by in-migration of lower skilled workers, then this tends to retard the process of moving towards higher value work, a feedback which one more time would seem to find reflection in lower wage levels on average in the younger age groups.

4) Impediments on pro-natal policies. The pressure on fiscal resources which result from the previous three factors mean that effectively it becomes increasingly difficult to generate the resources to finance really meaningful pro-natal policies which might attempt to "tease" fertility back up towards a higher level. As time goes by this problem only gets worse.

Easterlin and Macunovich

In the main Lutz bases his economic feedback mechanism on the cohort impact theory of Richard Easterlin and his associated relative income hypothesis. According to Easterlin changing cohort size produces either a crowding-out (the baby boom) or a crowding-in (declining fertility) phenomenon. The hypothesis posits that, other things being constant, the economic and social fortunes of a cohort (those born in a given year) tend to vary inversely with the relative size of that cohort, which is itself approximated by the crude birth rate in the period surrounding the cohort's birth. The cohort mechanisms operate mainly through three main social institutions – the family, school and labour market. Diane Macunovich has a good summary of Easterlins ideas and their application to fertility changes in Relative Cohort Size, Source of A Unifying Theory of the Global Fertility Transition (Macunovich, 2000).

The operation of this general 'crowding mechanism' means that large birth cohorts face adverse economic and social conditions, higher unemployment, and lower than expected wages, outcomes which are significantly at odds with their material aspirations. As a result, they postpone family formation and have fewer children. This line of research now represents a long-standing tradition in the United States, where an ongoing body of work (Easterlin 1975, 1978, 1980, 1987, Macunovich 1998a, 1998b, 2000, 2002, Bloom, Freeman, and Korenman, 1987, Korenman and Neumark, 2000) has posited the idea that the relative size of young cohorts entering the labour market has far-reaching implications for wages, inflation, unemployment rates, etc, as well as for a variety of cohort impacting factors like living standards and family behaviour. The core idea behind the crowding thesis is also now being applied in studies of the 'greying' phenomenon in the United States as the large 'boom generation' steadily approaches retirement age. .

On the other hand, the crowding-in syndrome would mean that the reduced cohorts which follow the fertility decline should find work more easy to obtain, and salaries relatively higher. The result are rising income expectations and aspirations for a better life all round. Insofar as these are realised there is an associated "birth spurt" as young people's confidence in starting families (or adding to them) grows and grows. This is the phenomenon we saw at work in Latvia - complete with the very high rates of wage inflation - in the years of boom. Now we see the other side of the coin, as the sharp contraction produced by the rapid deflating of the earlier situation throws everything into reverse gear.

So far Maconovich and Easterlin, but Lutz and his colleagues offer a further, and most suggestive) direction for further analysis: low fertiliy leads to the acceleration of societal ageing, this produces cuts in welfare and pension benefits, generates a general pessimism about the future and lowers expectations about future income. Thus those rising income expectations which were previously associated with those "narrow" cohorts, now become more difficult to sustain as the fiscal burden weighs down on younger generations, and this has the consequence that they continually postpone starting families. The general pessimism, coupled with pension reforms which reduce guaranteed benefits, when coupled with anticipation of increased life expectancy, produces an increase in saving for the future, which, of course represents a drag on current consumption. The drag on consumption leads to a far more lethargic level of economic growth, and this only adds to the negative cycle ny induce young people to delay further having children in order to attempt to maintain current income. This type of economic chain reaction, especially plausible in the light of what we have actually seen happening in Germany and Japan (the two countries who have advanced furthest in this particular demographic transition), does seem to be one of the possible mechanisms through which Lutz's trap - should it in fact exist - might operate.

In fact Macunovich takes the Easterlin theory and tries to use it to develop a general theory of the whole demographic transition as a process operating almost in its entirety via cohort effects, and at this level her argument is not convincing. The cohort dimension is however very evident in the US baby-boom phenomenon, and the subsequent fertility reaction, and indeed this is having the consequence that population ageing is being seen very much as a cohort phenomenon in the United States, but this US experience is perhaps hard to generalise. What is evident though, is that the cohort phenomenon, and the changes in economic dynamic that this produces, does generate very real and important short run effects, and this is just where Lutz's idea becomes important, since if the population process is not a homeostatic one (which it isn't at this point) but rather a path dependent one, where long run outcomes depend on short run changes, then the short run impacts we are seeing operating now in a country like Latvia (and Hungary, and Ukraine) become potentially very important, since - via another of Lutz's pathways (the population momentum one) they can in fact make the difference between long run sustainablility and unsustainability for a country, and I do with that the EU Commission and the IMF would open up their ears, and listen to this argument, at least just a little bit.

The Relative Income Low Fertility Trap Mechanism At Work In Latvia?

Well, as I said ealier the evidence for how a restricted cohort might lead to strong rising income expectations is clear enough, and now there is little doubt that Latvia is facing a very sharp economic contraction. This is leading to falling living standards, deteriorating employment stability expectations, growing pessimism, and of course (as we will see below) falling births.

Indeed only this weekend the Latvian Cabinet met emergency session, in order to reach to agreement a the package of measures to be put before parliament. These measures - I think it is hard to believe this part - as actually being demanded by the leaders of the European Union (via their representatives on the European Commission) in order to agree the release of the next tranche of the Latvian "bail out" loan. Among measures being discussed are a reduction of 10% in state pensions by 10% and ans a maternity and child care benefit cut of 10%. The former may be hard, but justifiable, the latter, as we will see, more or less amounts to voluntarily agreeing to slit your own thoat.

Let's take a look at the problem. Births have long been falling in Latvia. In the mid 1980s they hit a peak, at a little over 40,000 annually. Then, in harmony with what most economists and demographers woudl expect, fertility dropped to a historic low in the mid 1990s (under the impact of the transition shock) - with a peak to trough fall of over 50%. As we can then see, fertility has rebounded as we entered the late 1990s under the impact of rising living standards and due to the fact that more or less record numbers of people entered the childbearing age group.

Unsurprisingly then, the Latvian period fertility measure (the total fertility rate) started to tick upwards again from the record low of 1.12 hit in 1998.

But what has been happening to births since the crisis broke out? Well, fortunately the Latvian statistics office do publish monthly live birth stats, so this is one indicator we can track fairly easily. Here's the chart from the start of 2007, but there is so much volatility (seasonal variation?) that it is hard to see exactly what is going on.

However, if we apply an old economist's trick, and look at the year on year variation, the pattern gets a bit easier to see.

And then if we apply another seasoned economist's "quick and dirty" procedure to iron out a bit of the seasonal variation by smoothing with a three month moving average chart, the picture seems very clear indeed. As output drops, and living standards fall, so to does Latvian society's "production of children".

And of course, the negative population dynamic goes even further than this, since we have out-migration to think about. We have official monthly figures from the stats office, and even if these undoubtedly underestimate the size of the movement, the data quite possibly does give reasonable evidence of the trend, and what we can see in the chart below is not good news, since the rate of emigration is obviously rising.

Now these two factors, migration and births have a direct impact on a third indicator - population median age, and as we can see this is rising in Latvia, and very rapidly, with pronounced and important implications for both elderly dependence and economic performance. And of course, the median age assumptions for future fertility between now and 2020 where made on the more postivive outlook of improving fertility which prevailed before the crisis.

Now, from our more general studies of the economic impacts of ageing population, it is apparent to Claus Vistesen and I that the medain age of forty is something of a watershed for any population. The entire structural characteristics of an economy begin to change from this point in the ageing process, and the economy becomes increasingly export dependent as we can see in the case of high median age societies like Japan, Germany and Sweden.

But something is different in the Baltics, since male life expectancy is much lower than in the above mentioned countries, on average nearly 10 years lower, as can be seen from the comparison between Germany and Latvia to be seen in the chart below.

Now, from a strictly pragmatic point of view someone might be tempted to say, well "where's the problem there, less pensions to pay" (leaving aside the obvious humane issues), but this isn't the point, since the dependency ratios are set to rise sharply even assuming this mortality rate. The problem is that most of the remedies for offsetting the ageing population dependency issues assume the viability of raising labour force participation levels in the 55 to 65 age groups, and in the Latvian case many of the men involved - the ones whose infusion into the labour force is set to "dynamise" the economy - either simply aren't there, or are in very poor health.

So no, this is not simply one more plea for leaders of Latvia to get to work and devalue the currency. It is a plea to those leaders to stop and think a little about the implications of what they are doing. Surely no one can be happy to see their country flushed down the tubes in quite this way?


Bloom, D., R. Freeman and S. Korenman. 1987. “The Labor Market Consequences of Generational Crowding”, European Journal of Population, 1987, 131–176.

Easterlin RA (1975). “An Economic Framework for Fertility Analysis” Studies in Family Planning, 6(3):54-63.

Easterlin RA (1978). "What Will 1984 be Like? Socioeconomic Implications of Recent Twists in Age Structure," Demography, 15(4):397-432 (November).

Easterlin RA (1980). Birth and Fortune: The Impact of Numbers on Personal Welfare, Basic Books: New York.

Easterlin RA (1987). “Easterlin Hypothesis”, pp.1-4 in J Eatwell, M Milgate, P Newman (eds) The New Palgrave: A Dictionary of Economics 2, Stockton Press: New York.

Korenman S and Neumark D (1997). Cohort Crowding and Youth Labor Markets: a cross-national analysis”, NBER #6031,
Cambridge, MA.

Lutz, Wolfgang, Maria Rita Testa, Vegard Skirbekk, 2006. The "Low Fertility Trap" Hypothesis, Paper presented at the Population Association of America (PAA) 2006 Annual Meeting, March 30 - April 1, Los Angeles, California

Lutz, Wolfgang, Maria Rita Testa, Vegard Skirbekk, 2005. The "Low Fertility Trap" Hypothesis power point presentation at the Postponement of Childbearing in Europe conference held at the Vienna Institute of Demography, 1-3 December 2005, Vienna, Austria

Macunovich, D.J. 2002, Birth Quake: The Baby Boom and Its Aftershocks. Chicago: University of Chicago Press

Macunovich, D.J. 2000, Relative Cohort Size: Source of a Unifying Theory of Global Fertility Transition? Population and Development Review, Volume 26 Issue 2, June 2000

Macunovich, D.J. 1998a, Relative Cohort Size and Inequality in the U.S. American Economic Review (Papers and Proceedings) May 1998 88(2):259-264

Macunovich, D. J. (1998) “Fertility and the Easterlin hypothesis: An assessment of the literature.” Journal of Population Economics 11:53-111.

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