Paul Krugman, China’s Demographic Crisis, and the Which Way Is Up Problem in Economics

January 17, 2023

I rarely disagree in a big way with Paul Krugman, but I think he misses the boat in an important way in his piece on China’s alleged demographic crisis. Before getting to my point of disagreement, first let me emphasis a key point of agreement.

Krugman points out that many countries, notably Japan, have managed to do just fine in the face of a declining population and shrinking workforce. Their people continue to enjoy rising standards of living as their population shrinks. In the case of Japan, its population has been declining for more than a decade and its workforce has been pretty much stagnant over this period. Nonetheless, its per capita income is nearly 10 percent higher than it was a decade ago.

This actually understates the improvement in living standards enjoyed by the Japanese population over this period. The average number of hours worked in a year also fell by more than 7.0 percent, meaning a typical Japanese worker has more leisure time now than they did a decade ago.

It’s also worth mentioning that Japan’s cities are less crowded than they would be if its population had continued to grow. This means less congestion and pollution, less time spent getting to and from work, and less crowded, beaches, parks, and museums. These quality of life factors don’t get picked up in GDP.    

Japan has been running large deficits and built up a large debt to sustain economic growth in the last two decades, but this has not created a major burden for its economy. Its interest payments on its debt are less than 0.3 percent of GDP, compared to 1.7 percent of GDP for the United States. Its inflation rate has consistently been well below its central bank’s 2.0 percent target, although it did see a modest Covid uptick in the last two years.

This point about inflation is central. Back in the good old days, when the Peter Peterson anti-Social Security warriors were in their prime in the 1990s, the standard story on an aging society was that we would have too few workers to support all the old-timers. The retirement of the baby boomers was supposed to break the camel’s back. There would have to be massive tax increases, otherwise the government would run huge deficits which would lead to cascading interest payments on the debt. Alternatively, it could finance its deficits by printing money, leading to out of control inflation.

The Peterson story was never very honest, since the real factor driving its deficit horror story was the projection of exploding private sector health care costs. Since the government picks up roughly half the national tab on health care through programs like Medicare and Medicaid, the explosion in health care costs then being projected would have meant a massive burden on the public sector, even without the aging of the population.

As it turns out, we didn’t see anywhere near the explosive growth in health care costs projected at the time, but we have seen the aging of the population and an increase in the ratio of retirees to workers. But rather than seeing excess demand (Covid shutdown and recovery excepted), our problem has been inadequate demand. The same problem that has afflicted Japan.

This story, which now passes under the name of “secular stagnation,” is 180 degrees opposite the problem pushed by the deficit hawks. Back then, the problem of an aging population was supposed to be that we would be seeing so much demand that our shrinking labor force would not be able to produce enough goods and services. Now the story is that we see less demand with our aging population, so we will see weak growth, unemployment, and deflation.

It’s good that the economics profession has been able to adjust its theories to reality, but we should at least acknowledge the complete shift in perspectives. It is a bit embarrassing that the nearly universally accepted dogma within the profession twenty or thirty years ago proved to be the exact opposite of the reality.

On to China!

Okay, now that we know the terrain, the question is whether China should be terrified that its population is now falling, as all our leading news outlets are telling us?  Well, as people who have listened to the media’s sky is falling tales should recognize, China’s falling population crisis is just our old friend, the story of not enough workers to meet the demands of an aging population.[1] So the question is whether China’s economy will be able to meet the demands created by a growing population of retirees.

As Krugman correctly points out in his column, there is no reason in principle that China should not be able to support its elderly. The question is a political one of whether its government is prepared to establish adequate Social Security and Medicare-type systems to ensure that its elderly have sufficient income and decent health care. Not having any special expertise on China’s politics, I can’t answer that question, but it is important to recognize that it is not a problem of an inadequate labor force.

Where Krugman left me scratching my head was his discussion of this problem of shifting resources to support the elderly:

“For China has long had a wildly unbalanced economy. For reasons I admit I don’t fully understand, policymakers there have been reluctant to allow the full benefits of past economic growth to pass through to households, and that has led to relatively low consumer demand.

“Instead, China has sustained its economy with extremely high rates of investment, far higher even than those that prevailed in Japan at the height of its infamous late-1980s bubble. Normally, investing in the future is good, but when extremely high investment collides with a falling population, much of that investment inevitably yields diminishing returns.”

There are two points I would make here. First, while Krugman is entirely right about the high rates of investment preventing households from enjoying the full benefits of economic growth, it is worth noting that China’s population has enjoyed enormous improvements in living standards over the last four decades. In the 1970s, the standard of living for the bulk of the population was only slightly better in many respects than for people in Sub Saharan Africa.

Today, hundreds of millions of people in China have near European standards of living. Krugman is right that the country’s growth could allow for even more gains (especially in rural areas), but the enormous gains seen by the bulk of the population probably meant that there was more tolerance for waste than in a context where say, a declining workforce was leading to stagnant or declining living standards.

The other point is simply the flip side of Krugman’s point about the massive investment spending in China. This is a waste of resources that can in principle be converted to meet the needs of the elderly population. In other words, if anyone believed the not enough workers story, we can point to all the people and resources tied up in nearly pointless investment projects. They could instead be building hospitals, retirement facilities, and in other ways producing the goods and services demanded by a growing elderly population. Of course, China couldn’t accomplish this sort of conversion overnight, but its population isn’t aging overnight.

Again, if China can undertake this sort of conversion is a political question. Maybe people more expert on China’s politics can answer it, but it clearly is not an issue of too few workers to meet the demands of an aging population.

One final issue: as I have pointed out on many occasions, the impact of even modest rates of productivity growth swamp the impact of demographics. China’s productivity growth has slowed in recent years, but even at a pace of 3-4 percent annually (what we have been seeing in recent years), it should easily be able to produce enough so that in ten or twenty years both workers and retirees can enjoy much higher living standards than they do today.

Whether its productivity growth will continue at recent rates, or slow further, is an open question, but anyone claiming that it will not have enough output to be able to support its retirees is predicting a massive slowing of productivity growth. For what it’s worth, the International Monetary Fund (I.M.F) is projecting that China continues to sustain strong productivity growth. It projects that GDP growth will average more than 4.5 percent annually even as its workforce shrinks.  

The I.M.F. projection can of course be wrong, but clearly it does not accept the declining population crisis story. For now, that one is best filed under “fiction.”  

[1] There is also the silliness around turning negative. There is very little difference to the economy if its population or labor force is shrinking slowly, say 0.2 percent a year, or growing by the same amount. We saw the same hysteria around the issue of deflation, as though economies would somehow face a crisis if their rate of inflation was a small negative number instead of a small positive number. The lesson that actually serious people everywhere know, is that crossing zero doesn’t matter.


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