There are two questions that we'll seek to answer in this post:

1. How might the change in a nation's population over time affect its rate of inflation?
2. Are U.S. baby boomers the most inherently evil generation ever in economic history?

Before we go any further though, for the sake of eliminating the suspense involved, here are the answers to both questions:

1. Predictably.
2. Yes.

We are being a bit facetious with our second question, but let's see if you don't draw a similar conclusion after we work through the first question.

That question arises as we've recently been looking to develop a model for anticipating the future rate of inflation in the United States, which we could then incorporate into the kind of tools we develop and make available to everybody in the world here at Political Calculations. In doing that, we began with a July 2006 paper by Ivan Kitov, a geophysicist whose work in economics we first became familiar with back in 2005 (via one of David Smith's discussion forums, whose archives unfortunately appear to only go back four years), which has intrigued us for some time: Exact Prediction of Inflation in the USA.

In the paper, Kitov presents his findings of a remarkable correlation between the measured rate of inflation observed in the U.S. and the change of the size of the U.S. workforce over the years from 1965 through 2002, which is observable in the figure we've excerpted from the paper. In this chart, we see that inflation, as measured by the GDP deflator, closely follows the trajectory determined by the change in the size of the U.S. labor force (dLF) with respect to the total labor force (LF) some two years earlier. In simpler terms, changes in the rate of inflation in the U.S lag the change in the relative size of the U.S. labor force by a two year period.

How That Might Work

How might changes in the size of the US. workforce drive changes in the U.S. inflation rate? We suspect that the answer to that question lies in the change in consumption patterns driven by those entering and exiting the U.S. labor force.

As individuals first enter into the labor force, a good portion of their personal consumption of goods and services becomes driven by things related to their work. Things like increased expenditures for clothing suitable for their work, transportation, housing, and the cost of all things related to these kinds of consumption items lead to a relative increase in the demand for these goods and services.

This consumption pattern is sustained throughout an individual's working life, until they retire. Shortly after retirement, personal consumption expenses tend to drop sharply, as work done by Mark Aguiar and Erik Hurst demonstrate in their 2008 paper Deconstructing Lifecycle Expenditure. We've excerpted a chart from this paper (left) to show how attaining retirement age would appear to affect personal consumption.

This chart runs for individuals from Age 25 through Age 75, showing the log deviation in personal consumption expenditures from the level recorded for 25 year olds. We see personal consumption rising from Age 25 through Age 45, peaking in the range between Age 45 and 55. After Age 55, as retirement takes place, total personal consumption expenditures (the top pink line) fall steadily before leveling out over Age 65, the generally accepted age of retirement in the U.S.

The chart to the right illustrates that the drop in consumption coincides with the rather dramatic reduction in the fraction employed and hours worked for individuals over Age 60. Aguilar and Hurst argue that this change in individual personal consumption is driven almost entirely by the individual's departure from the workforce. Simply put, they reduce their spending by the amount they previously incurred to participate in the workforce over their working portion of their lives.

Why the Baby Boomers Are Inherently Evil

Now that we've established that work drives certain kinds and levels of personal consumption at different points in an individual's life, let's consider what happens when we apply that kind of lifecycle spending pattern to millions of individuals.

Here, if the aggregate number of individuals entering the workforce increases each year, we can reasonably expect that the relative increase in the demand for the work-driven goods and services that they consume would tend to drive prices higher. Conversely, if the aggregate number of individuals exiting the workforce each year increases each year, we can reasonably expect that the relative increase in demand for work-driven personal expenditures will fall, taking prices lower with them. Meanwhile, if the aggregate number of individuals both entering and exiting the workforce are nearly equal over time, we can expect that prices will remain fairly stable.

Beginning with that idea of stability, let's consider the effect that we might expect the baby boom generation's entry and pending exit to the U.S workforce to have upon the rate of inflation in the United States. The baby boom generation consists of those individuals born between the years of 1946 and 1964. During these years, the number of people born in the U.S. were substantially higher than in the two decades both preceding and following.

Adding 18 and 22 years onto 1946, we see that significant numbers of baby boomers would begin entering the U.S. workforce in large numbers in 1964 (for those with a high school education) and 1968 (for those graduating college.) Adjusting for the two year lag between the change in the size of the U.S. labor force and a correlating change in the rate of inflation, we would reasonably expect to see a surge and sustained increase in the level of the U.S. inflation rate, first beginning in the years from 1966 through 1970.

That is, in fact, exactly what we do see as the average annual rate of inflation jumped from a range of 0.7% to 1.9% in the years from 1961 through 1965 to a range of 3.0% to 6.2% from 1966 through 1970. More than that however, we see inflation continue to run at high levels throughout the baby boomer entrance into the U.S. workforce.

But what happens when the net number of individuals entering the workforce is no longer climbing with respect to the aggregate number of individuals leaving the workforce? Or better yet, what can we expect as the leading wave of baby boomers begin retiring in large numbers. Kitov explains:

The changes in the inflation behaviour observed in the 1970s and 1980s are a pure consequence of the accelerated labor force growth associated with the measured participation rate increase (Kitov, 2006a). There were two distinct phases in the participation rate increase separated by a short period of "quietness". When reached its peak value around 1983, the participation rate effectively stalled at the attained level and has not been changing since then. As a consequence, the labor force has been growing only due to the growth in working age population. This period is known as "Great Moderation" and was possible completely due to the constant participation rate and population growth at an annual rate above 1.0% since 1983.

The "Great Moderation" is currently approaching its natural end. The labor force projections made by various institutions (CBO, 2004; BLS, 2005) undoubtedly indicate a decrease in the participation rate and a decaying growth rate of the working age population. According to the projections, staring from 2010, the annual increase in labor force will be less than 1,200,000 – the value separating inflation and deflation. Hence, a deflationary period is very probable starting 2012 because of the two-year lag between the labor force change and inflation.

In relying upon the CBO's and BLS' labor force projections, Kitov is off by several years for projecting the onset of a period of deflation to begin in the United States. Going by the workforce participation rate observed by Aguilar and Hurst, for which Age 60 marks the beginning of a sharp reduction in the average number of hours worked per individual coinciding with retirement, which the leading edge of baby boomers would reach in 2006, we would anticipate a sustained period of deflation to begin in 2008, given Kitov's observed two-year lag between change in labor force and change in inflation rate.

And so we see that in addition to perhaps driving the high rates of inflation in the 1970s, the baby boomers very existence may also be driving the deflationary forces that are giving Fed Chairman Ben Bernanke the worst kind of nightmares these days. We therefore conclude by finding that U.S. baby boomers are perhaps the most inherently evil generation ever in the economic history of the world.

Labels: demographics, economics, forecasting, inflation

- posted by Ironman at 1:57 PM | Permalink | Home |