The next financial collapse could be caused by demography

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There is a view that the market will sort out all the problems that low fertility creates, and that rising real wages in an era of labour shortages are an example of this. This perspective was very much in vogue on the pro-market right during the 1970s and 1980s, so it is no coincidence that I was reminded of it when sitting next to a former Thatcherite Cabinet minister at a dinner not long ago. A lively discussion was underway about immigration, with one contributor arguing that high levels of immigration were inevitable given labour shortages. The retired politician replied more or less as follows: ‘Whatever the arguments for or against immigration, it is preposterous to justify it on the basis of so-called labour shortages. Every input into the economy has a price, and if the input is scarce, the price goes up until supply is stimulated and demand dampened and there is no longer a shortage.’

Markets are indeed a human institution of near-miraculous qualities that, as Adam Smith long ago pointed out, serve society through the efficient allocation of resources, even if none of the actors inside the system are privately pursuing that goal. The place of markets in human affairs, their strengths and their limitations, has been widely and intensively debated, and this is not the place for these arguments to be rehashed. But it is worth thinking through exactly what a market-based approach to the problems of demography would mean, and whether it could indeed contain a solution. For sure, there is a finite supply of capital and land and labour, and each will be partially or fully priced (depending on the appetite for government intervention) to reflect supply and demand. But the impact of a low supply of labour relative to the population it is serving – that is, in effect, the impact of a high old-age dependency ratio – is something relatively new. Historically we have not been used to societies or economies of this sort. And we may not like the consequences.

Higher costs of social care and healthcare

Imagine we lived in the perfect market society that the former Cabinet minister perhaps aspires to. There would be minimal state support for any services: everything would be run by private corporations. A shortage of labour and a rise in its price would choke off demand for it by those with the least ability to pay. The less well-off would have no access to a doctor, a dentist, a nurse or even an ambulance. Elderly and infirm, they would find nobody to care for them, and absent family members prepared to help out, they would sit neglected, waiting for death. There would be no teachers for the children of the less well-off, nor any school buildings in which to educate them.

Fortunately, we do not live in such a society. Far from it. We have a welfare state, where the government provides what are generally considered essential services. As societies age, they look more and more to the state. Older people consume more of the goods and services that electorates expect to be delivered by the state rather than by the market. They are more likely to require the services of doctors, nurses and carers, and to consume more household fuel, which we expect the state to provide or to subsidise either universally or for poorer individuals. In France, the state spends over 50 per cent of GDP, and in the UK and US, not much less. There are those who call for a smaller state, particularly in the Anglosphere, and promise lower taxes. But this is an unrealistic aspiration given our current demographic condition. More and more will be expected of the state as ageing populations require higher levels of social care and healthcare and a larger share of national spend through pensions. The state in the developed world, which is expected to provide a wide array of services, will find itself increasingly hard-pressed as it becomes obliged to deploy and to finance an ever-growing share of the shrinking national labour force to provide the services its electorates demand.

«More and more will be expected of the state as ageing populations

require higher levels of social care and healthcare and a larger share of national spend through pensions.»

The financial result of this will be a combination of rising taxes and growing government debt. We have already noted how countries with the worst and longest-standing ageing problem, like Japan, Greece and Italy, tend to have the worst levels of government debt to GDP among the rich countries. In Japan debt has reached well over 200 per cent. What societies demand from the state, and what they are prepared to pay for this in the form of taxes, are not the same thing. Expectations both of state provision and of an acceptable level of taxation were set in an era when young taxpayers were burgeoning and those requiring pensions and intense healthcare were relatively few and far between. Although ageing changes this equation, it is not something that electorates understand, or want to understand. They still want to keep and freely spend most of their income and savings, while expecting the kind of provision outlined above. The result is that governments resort to borrowing to fill the gap.

In some ways this works rather well. Until the rise in inflation and interest rates in the early 2020s, governments could borrow at remarkably low interest rates. The yield on Japanese government bonds in August 2023 was still negative for a year, and well below 1 per cent for ten years. In part this reflects the deflationary expectations of investors, a function of a demographically driven pessimism about the prospects of the Japanese economy. It also reflects the fact that Japanese investors, being old, are looking for the safest class of assets available and are happy for now to park their savings with the government rather than risk them in local equity markets that have delivered decades of lacklustre and even disastrous performance. The Japanese saver, at least, is prepared to fund the deficits of the Japanese government. And a great deal of Japanese government debt has simply been bought by the Bank of Japan, paid for by a long-standing and vast programme of quantitative easing.

But bankruptcy, as a character in an Ernest Hemingway novel famously said, happens gradually then suddenly. There is no way to be certain when the printing of money to finance debt will trigger inflation. The inflation of the early 2020s in many countries, coming after years of fast money-printing, was not generally expected. And panics over the reliability of a debtor’s creditworthiness can likewise happen quite suddenly.

The future is with us

With the prospect of endlessly mounting government debt, such an occurrence cannot be discounted with any more certainty than its timing can be predicted. But if and when it happens, the entire economic and political system could collapse. In the summer of 2023, one of the major ratings agencies downgraded US government debt, traditionally seen as the absolute last word in risk-free assets. Credit rating agencies are linking a loss of faith in government finance with ageing. ‘In the past, demographics were a medium- to long-term consideration. Now, the future is with us and already hitting sovereign credit profiles,’ says a representative of Moody’s. ‘While demographics are slow-moving, the problem is becoming more urgent. We are well into the adverse effects in many countries, and they are only growing,’ says a senior executive at Fitch. Without doubt there are many complex reasons for this, but the underlying fiscal problems of the US and the rest of the developed world would look very different if they had the young and growing populations that characterised these countries 30 or 40 years ago.

«The underlying fiscal problems of the US and the rest of the developed world would look very different if they had the young and growing

populations that characterised these countries 30 or 40 years ago.»

When the financial credibility of the banks was shot in 2008, only the action of governments, the ultimate source of creditworthiness, could save the system. If and when the financial credibility of governments collapses, there will be no final backstop available. The last time there was a meltdown on anything like such a scale, the consequence was a rising tide of communism, fascism and war. The precise form the crisis will take next time is anyone’s guess, but it is unlikely to be pleasant. Even if such a financial Armageddon never takes place, we need a population revival to return the developed countries to the kind of demographic condition they were in 50 years ago. And even if we were to fix the fertility rate tomorrow, that would not happen for decades to come.

This essay is an excerpt from the book “No One Left” (Forum, 2024).