Growth Theory and Demographics (Wonkish)

With the Fed/QE singularity still dominating the markets I thought it would be time for an academic digression  since I am sure you don't need me to point you to sources on the current market climate (especially not in earnings spam week).

The one is a real treat and essentially is a literature review of how endogenous growth theory has incorporated the issue of population ageing into growth in the long run. It is written by Klaus Prettner and Alexia Prskawet and is out of the Vienna Institute of Demography which is one of the top 3 (in my opinion) constellations that produce material on the link between demographics and macroeconomics.

The purpose of this article is to identify the role of population size, population growth and population ageing in models of endogenous economic growth. While in exogenous growth models demographic variables are linked to economic prosperity mainly via the population size, the structure of the workforce, and the capital intensity of workers, endogenous growth models and their successors also allow for interrelationships between demography and technological change. However, most of the existing literature considers only the interrelationships based on population size and its growth rate and does not explicitly account for population ageing. The aim of this paper is (a) to review the role of population size and population growth in the most commonly used economic growth models (with a focus on endogenous economic growth models), (b) discuss models that also allow for population ageing, and (c) sketch out the policy implications of the most commonly used endogenous growth models and compare them to each other.

As you migth remember I started a blog series some time ago on macroeconomics and demographics and in the first post (second is coming soon on demographics and asset prices) I basically laid out some picture points in the context of life cycle theory and demographics. One of these topics included growth which in itself is illusive but also a topic which almost deserves its own label outside traditional macroeconomics since it is a field which is so vast yet pretty strict in methodological terms. The paper by messieurs Prettner and Prskawet is a very good re-cap of the literature (I am definitely going to read 5-6 papers on their ref list) and brings you up to date on how growth theorists model the effect of population ageing on growth in the long run.

The general conclusion is, contrary to the classical Solow model, that population dynamism is positively related to growth or that population ageing is a drag on growth in the illusive steady state. This comes with some qualifiers of course, but as I read the evidence it is pretty much overwhelming from the models we already have. This is an intuitive result, but also a big one in relation to growth theory where the incorporation population ageing has been very long time underway. Moreover, since the contributions who stipulate this are only from the second half of the first decade of the 21st century I think we can call this an advance of no small nature!

So far so good then.

However, apart from the strides made in the context of growth theory I also asked the question of whether steady state growth theory, in general, was suited to explain the phenomena we really would like to explain. Specifically, I said ...

The basic problem here though remains the concept of the steady state which means that we must construct model such as to allow the change of capital through time (or its derivative with time) to be 0 in the long run. Note here that this condition is not imposed on the basis of empirical behaviour but on the basis of (mathematical) analytical tractability. So, apart from the uncertainty surrounding exactly what this ”long run” is, it also locks in the analysis and assumes away a large part of the important aspects of even basic life cycle behavior. Specifically, the idea that once reaching a steady state any change in the savings/consumption rate will one have transitory effect and that the economy will automatically (and always) converge to the same growth rate/state as before is a problem. Essentially, the whole idea of a steady state whether be it in the form of an exogenous or endogenous growth theory framework is a huge problem since it is evident that such a thing does not exist. And even if we could establish over a very long run horizon that such an average/constant path is a good approximation we would be ironing out all the interesting and important questions in the process.
Consider for example the model presented in Gruescu (2007) (see list of references in the paper [1]) and the prediction that growth in the long run is a negative function of a growing dependency ratio. This seems logical and intuitive but this also becomes a problem as Prettner and  Prskawet rightly points out since we can't really assume that the dependency ratio grows in the steady state since what happens when it becomes 1 (its natural limit?). As it happens, the idea of a growing dependency ratio in the long run and indeed a growing drag from ageing is exactly the right assumption in most OECD economies. Thus, for all intent and purposes what constitutes the long run for them is equal to a growing share of the elderly in the population.
But the problem is more fundamental since we are reducing a dynamic and path dependent parameter (ageing) to a growing constant in steady state in which growth itself is constant as a function of a some form of technological growth rate (in this case exogenous, but it need not be). Indeed, I think it fair to say that this is an onthological issue that we have not yet adequately addressed or which has not yet been duly formulated. My point is simple; in order for something to be important in the steady state, it must be exhibit a constant and stable growth rate. Demographics and the effect it exerts on economic processes are neither constant nor stable (although again, the idea of a constantly growing dependency ratio is not that far fetched).
But I digress.
The frontline in growth theory has come a long way in explaining the association between long run growth and demographics and while, as the authors point, out much depends on the modelling framework and thus the underlying assumptions on how relevant inputs to growth are created and transformed into output I think (and hope) that empirical observation and falsification will determine which frameworks that end up as the best models to explain growth.
One thing is sure, the paper by Prettner and  Prskawet is a great tour of the most important models and their implications. If you are doing any kind of work on this, you want to read it.
[1] - Basically, Gruescu (2007) explores a classicl Solow model and augments it with population ageing. I have not gone through the model, but it looks pretty neat. So it is a good place to start.