Facing the economic test of an older and cheaper world

THOSE TWIN D-words - deflation and demography - loom ever larger.

With each month that passes the likelihood that the world is entering an era of deflation has become more and more the mainstream expectation of the markets - even if they have yet to accept fully the implications this might have for share valuations. As for the impact of the ageing of the population of the developed countries, this too is now well appreciated, although few governments have accepted that the present structure of pay-as-you-go public pension schemes is unsustainable.

But the possible links between these dominant forces of the next quarter- century are largely unexplored. Yes, we know that a world where prices are as likely to fall as rise will be utterly different from one where inflation has bailed out poor investment decisions. And we can begin to think about what might happen to economies where the workforce is falling in size and the burden of pensioners is growing. What has not happened is systematic exploration of the links between the two.

You will be relieved to know that I am not going to attempt this here: it would need a book rather than a newspaper article. But some sensible things might be said, particularly if you start from the evidence of what seems to be happening in Japan.

Japan is interesting for two reasons. First, it is the only Group of Seven economy that has experienced sustained deflation in the 1990s. Consumer prices have been stable or virtually so, while producer prices have nudged relentlessly down. (Asset prices have plunged, but that is another story.)

Second, Japan is experiencing the fastest demographic transition of any G7 country from youth to age. It was until the 1960s the youngest of the G7 in terms of the proportion of the population over 65. It is now in mid-pack, but within 10 years it becomes the oldest. This year is also transitional in another way: for the first time ever the labour force is starting to shrink.

What are the possible links? One potentially important one is shown in the chart, drawn up by the economics team at Merrill Lynch. It shows how the size of the twentysomething age group is set to fall sharply in the next 10 years, and relates that to the fall that has been taking place in the consumer price index.

The fall in the proportion of young workers has several effects. For a start, the new technologies seem to place a big premium on youth in the sense that young people seem better able to produce and use them. So a decline in their numbers is a double weakness - on both the supply and the demand side.

There is also a saving/spending effect, for young people tend to spend a higher proportion of their income than old. So Japan's savings ratio, already high, might rise even further. Older people, interestingly, tend to remain significant net savers even in retirement.

But is there in addition a deflation effect? I don't think there is a direct relationship, but there may be an indirect one. Trends in prices are partly global. All countries experienced the great inflation of the 1970s and early 1980s, and all are experiencing the present disinflation, maybe deflation. But some are undoubtedly more inflation-averse than others. In Europe, Germany has long been more concerned about inflation than, say, Italy or France. The usual explanation for this is differing political and economic experience; in the case of Germany, the experience of hyper-inflation between the wars. But demography may also have some impact.

There is a political calculation. The older the balance of the population, the less likely the electorate is to want to see its savings whittled away by inflation. By contrast, younger people, who are in a relatively strong position in the job market, are not likely to be as concerned about inflation because they can use their strong bargaining position to increase their earnings to compensate.

Now, I would not suggest that deflation in Japan is the result of an age-related shift in political values. But deflation is at least consistent with the interests of the growing proportion of the population: many older people in Japan, living off their savings, have done quite well as a result of falling prices. (Yes, they have suffered from falling money-interest rates, but interest rates have long been low in Japan - real interest rates are decently positive now, whereas 10 or more years ago they were negative.)

There is a further economic impact. A declining - and older - workforce will make it more difficult to maintain good productivity increases unless there is relatively rapid restructuring of the economy. If Japanese productivity grows only slowly, the economy can grow, at best, only slowly. Slow growth is likely to intensify the deflationary cycle.

Intuitively, this feels right: older societies will tend to be associated with stable prices, young ones with inflation. So, while there is no direct link between demography and deflation, there are probably quite strong indirect links - which, if true, have profound implications for other developed economies.

For a start, older European societies such as Germany, France and increasingly Italy seem more likely to experience deflation than younger ones such as the US. By European (though not American) standards, the UK will become relatively young, for it is ageing less rapidly than the main continental countries. So we may turn out to be somewhere in the middle in the deflationary stakes.

Next, there is a question as to whether deflation will be associated with poor economic performance, as it has in Japan, or whether countries will learn to grow reasonably quickly despite generally falling prices. I don't think we can begin to guess at the answer to this, except to note that in the past both falling and rapidly rising prices seem to have been associated with slow growth, while stable or slowly rising prices have generally been associated with solid growth.

There is an enormous challenge ahead to adjust to demographic change, not just in public finances but in the way increasingly scarce young workers are used - and the best use is made of the growing army of older ones.