China’s Aging Problem

38 THE INTERNATIONAL ECONOMY FALL 2006
China’s
Aging Problem
Limited options, ominous risk.
Demographics are becoming a big challenge to China’s future
growth dynamics. The graying population will have far reaching
implications for the country’s economic policy, structural
reform, and investment return. The cause-effect sequence runs
as follows: An aging population leads to a shrinking labor
force, which reduces the marginal product of and hence the
return on capital. Investment will thus fall due to lower returns.
This means a vicious chain effect—when labor falls, investment
falls so that output and living standard fall too.
The only way to keep or raise the living standard on the back of aging population
is to raise productivity. This needs deeper structural reform. It also needs more capital
formation. But capital formation will not rise unless capital return rises, and this highlights
an important policy implication. To raise the return on capital in the face of a
shrinking labor force, China has to keep a loose monetary policy bias in the long-term,
as low interest rates are needed to stimulate investment. The government will also need
to give tax incentives and improve technology to help enhance the return on capital in
the long-term.
These implications also apply to Europe whose population is likewise aging. But
they have even greater relevance to Japan, whose population has started to fall this
year. Behind the Bank of Japan’s pledge to keep interest rates very low after it ended
quantitative easing and zero interest rate policy recently is this tight demographic constraint
on monetary policy. Meanwhile, Japan’s acceleration of structural reforms since
2001 has indeed reflected its vision to put in place long-term solutions to tackle the
demographic challenge. The lesson for China is that with the proper response, it can still
enjoy sustainable growth even in the face of adverse demographics.
COMPARATIVE DEMOGRAPHICS
The falling demographic trend in China (and Europe and Japan) contrasts with growth
in the United States, which benefits from a fertility rate close to the replacement rate and
Chi Lo is an economic strategist based in Hong Kong and author of Phantom of the
China Economic Threat (Palgrave Macmillan, 2006).
BY CHI LO
THE MAGAZINE OF
INTERNATIONAL ECONOMIC POLICY
888 16th Street, N.W.
Suite 740
Washington, D.C. 20006
Phone: 202-861-0791
Fax: 202-861-0790
www.international-economy.com
FALL 2006 THE INTERNATIONAL ECONOMY 39
LO
high level of immigration. Europe’s net immigration is not
enough to offset its low birth rate and Japan has no net
immigration. The major economies in Asia are facing a
similar trend, as economic liberalization, rapid development,
better education, and changing values are prompting
later marriage and fewer children. Hence, birth rates
fall, the workforce shrinks, and the share of the graying
population rises.
Asia’s four biggest economies—Australia, China,
Japan, and South Korea—are all affected by the aging phenomenon.
According to the United Nations Population
Division estimates, 30 percent of the populations of China
and Australia will be older than sixty by 2050, while South
Korea’s figure is 36.9 percent. Japan’s aging phenomenon
is the most serious, where 42.4 percent of its population is
expected to be aged sixty or older by 2050. On the other
hand, only 25.5 percent of the U.S. population will be over
sixty years old by 2050.
THE DEMOGRAPHIC CONSTRAINT
The impact on the economy, investment, and living standard
of an aging population can be seen in the neoclassical
production function, which states that output is a function of
capital and labor inputs and technological changes. The first
point to note is that as the population ages, the returns to
different factors of production—land, labor, and capital—
will change. This is because the factors’ relative scarcities
will change. Second, the return on any factor of production
is its marginal product, or the increment to output from an
extra unit of that factor being added, holding the amount of
all other production factors constant. The extra revenue
added by an extra unit of capital is the return on capital.
The neoclassical school of economics argues that an
aging population should depress the return on capital. This
is because according to the structure of the classical production
function, changes in the factors of production being
used have feedback effect on each other. Labor is more
productive when more capital is added, and capital is more
productive when there is more labor. This is simply the flip
side of the law of diminishing returns. Thus, adding capital
raises the marginal product of labor and hence the return
on labor, which is wage. By the same token, adding labor
raises the return on capital.
Here comes the problem with an aging population and
a shrinking labor force. If adding labor raises the return on
capital, then reducing labor, as an aging population will
do, will lower the return on capital. If the return on capital
is lower, investment will fall and so will the capital stock.
When both labor and capital fall, output falls too. In an
aging economy like that of China, where the labor force is
shrinking faster than the population, the standard of living
will inevitably fall. The chain reaction becomes vicious—
an aging population will lower the return on capital, which
will lower the capital stock and lower living standards, all
else being equal.
RELAXING THE CONSTRAINT
However, the political economy school argues that the outlook
does not have to be so grim because other things are
not constant. Government and society can respond to the
demographic changes to prevent the fall in the living standard.
The key is to raise productivity, so that the economy
can produce at least the same amount with a smaller labor
force. The political economists use the following simple
relationship between output and inputs (capital and labor)
to explain their argument.
Output (Y) can be expressed as (Y/L) x L (i.e. Y =
(Y/L) x L), where L is labor and Y/L becomes output per
unit of labor input, or productivity, which depends largely
on the capital stock. Then relate this to the aging population
problem. If P is population and if we divide both Y and L
by P, the output/input relationship under the political economy
school’s interpretation then becomes Y/P = (Y/L) x
L/P. Y/P is just output per capita, but it is also a proxy for
the standard of living. Y/L is productivity and L/P is the
labor participation rate.
This simple mathematical manipulation has important
meanings. It states that living standard (Y/P) is equal to
productivity (Y/L) times the labor participation rate (L/P).
The key point to note in this simple model is that the relationship
between the labor force and the population is not
stable. In fact, this is a major flaw in standard growth models,
which usually assume the number of workers (which is
in the labor force) equals the number of consumers (which
is the whole population). But this is simply not true.
To raise the return on capital in the face
of a shrinking labor force, China has to
keep a loose monetary policy bias in the
long-term, as low interest rates are
needed to stimulate investment.
Continued on page 63
FALL 2006 THE INTERNATIONAL ECONOMY 63
LO
With an aging population, China’s labor participation
rate (L/P) is going to fall in the decades to come. To
keep living standard (Y/P) constant, productivity (Y/L)
must rise to offset the fall in labor participation. How
can productivity rise? From an investment perspective,
one way to do that is to raise the return on capital. This
will boost capital formation to augment labor productivity
and ultimately national output or GDP.
POLICY IMPLICATIONS
Both the neoclassical school and political economy
school of thoughts have relevance to economic policy
tackling the aging population problem. An improvement
in the technology level in the economy will raise returns
on both labor and capital, as reflected in the neoclassical
production function. Thus, government policies to
enhance overall productivity will help maintain living
standards, despite a shrinking labor force. Policies that
favor the income distribution towards capital will also
raise the return on capital, which will enhance capital
formation and, in turn, raise labor productivity and output
under the political economists’ framework.
Granted, labor will lose out to capital in a relative
sense under those capital-enhancing policies, as the
share of income going to labor will be lower. But labor
needs not lose in an absolute sense. Since increasing the
capital stock also raises the marginal product (or productivity)
of labor, the return on labor—wages—should
also go up. Thus, if the tilt of income distribution toward
capital generates a large increase in the capital stock,
wages will rise on balance. Note that technology
advancement will also help boost wage growth.
Meanwhile, a shrinking economy and/or falling living
standard will benefit no one. Thus, labor is better
off with a smaller share of a bigger pie than with a larger
share of a smaller pie, as the former could still be larger
than the latter in absolute terms. This is especially true
when the burden of sustaining an aging population is
considered. In economic sense, growing the pie is Pareto
optimal, as everyone benefits from the reallocation of
resources.
The private sector will not react to the problems of
aging population by increasing investment because the
marginal product of, or return on, capital falls in the first
place when the labor force falls. Thus, the government
needs to step in and change the incentives in the economy
to boost capital formation. This is why the drive
for structural reform is so crucial in an aging society.
The need to enhance the return on capital, so as to
encourage capital deepening to raise productivity,
indeed constrains China’s monetary policy to a loose
bias over the long-term. This is because low and stable
interest rates are needed to boost capital formation.
Meanwhile, preferential tax policies for investment and
structural policy to promote technological advancement
can also boost investment in the long-term.
Japan offers an example for China in terms of reactions
to an aging population. Japan’s problem is more
imminent than that of China, as its population has started
falling this year. Though slow, the Japanese government
is reacting to the adverse demographic implications by
creating better technology and tilting income distribution
towards capital. It has changed the tax system to
favor investment, with capital gains tax cuts, and rely
more on consumption taxes to fund the government budget.
It has also broken the barriers to reform and pushed
structural changes to reduce economic distortions and
enhance productivity of the country. The implications
for China are clear: these capital deepening and productivity
enhancing measures will help deliver sustainable
growth even in the face of adverse demographics.
On a closing note, the demographic constraint is
less binding for the United States because it is the only
advanced economy that has a fertility rate of 2.1, which
is also the replacement rate for keeping a population
stable. From the demographic perspective, this means
that the United States will enjoy greater monetary policy
freedom, thanks to its more favorable immigration
policy, than other economies with aging population.
Nevertheless, policies for enhancing returns on capital
and productivity growth remain paramount for sustaining
growth in the increasingly competitive global
economy. ◆
Standard growth models usually
assume the number of workers (which
is in the labor force) equals the
number of consumers (which is the
whole population). But this is simply
not true.
Continued from page 39