Opinion

The Great Debate

America’s aging population undermines monetary policy

Last week the Fed announced it would keep buying assets, for now, to keep the economy afloat. But that raises the question: why haven’t all the Fed’s efforts so far worked better?

One reason is that the economy constantly evolves and each recession is different; that alters the way monetary policy is supposed to work. The latest recession is notable for the way it destroyed households’ wealth. Median household net worth fell nearly 40 percent between 2007 and 2010. The severity of the recession also heightened awareness that the world is riskier than many people thought. Each of these factors make people want to save more. The Fed’s policy is to keep interest rates low to juice demand. But the state of household balance sheets going into the recession and the aging U.S. population may be why the Fed has not been more successful.

The Fed is currently buying bonds and mortgage-backed securities to keep interest rates low. The low rates are supposed to increase demand through several different channels. One way is through firms; if you lower real interest rates it’s cheaper for them to invest, expand and hire. Also, low rates encourage more consumption. They lower the returns to saving so it’s cheaper to consume today instead of in the future. This is called substitution effect. Or, the lower rates change how wealthy you feel — this is a wealth effect.

However, whether the substitution or wealth effect dominates, and how strong each is, depends on the age of the consumer. A recent paper from the IMF points out that the aging population may result in less effective monetary policy.

Older people hold the most wealth and savings; they are more sensitive to the wealth effect. Lower rates are supposed to make savers feel wealthier by increasing stock prices and encouraging investment in riskier assets. But that is inconsistent with life-cycle investing: as people near retirement they are usually advised to move out of risky stocks and into safer bonds. Encouraging the near-retired to take on more risk exposure than they’d like may have adverse consequences. They may anticipate having an uncertain future income, and save more to hedge future shocks. Also post-crisis, older people are investing less in equities. Between 2007 and 2010 the share of equities in the portfolio of 65-to 74-year-olds fell from 55 to 44 percent.

Can the G20 do “big” outcomes?

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George Magnus is Senior Economic Adviser, UBS Investment Bank, and author of “The Age of Aging: How Demographics Are Changing The Global Economy And Our World”. Any opinions expressed are his own.

The election of Barack Obama as president of the United States has unleashed a welcome torrent of optimism during hard times. Aside from an especially demanding domestic policy agenda, the new president will also have his work cut out to rebuild the authority of and respect for U.S. leadership in the global community.

The G20 meeting in Washington on November 14-15, billed as the forum for rebuilding the world’s financial architecture, could not be happening at a more important time. We should be under no illusion, however, that results will occur in a week, despite the expectations. Anyway, the G20 has the more pressing issue of countering global financial instability and the global recession.

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