US Labour Participation: Andrew Smithers and Lessons from Japan

The analytical debate about the fall in the US labour participation ratio essentially revolves around the degree to which potential pensioners are deferring or taking retirement in response to the impact of the great financial crisis. It's a genuinely important argument because on it turns estimates of likely potential growth rates and the size of the output gap (if any). Since these are key inputs into most monetary policy decision models, the stakes could hardly be higher.

Andrew Smithers' piece in the FT today  is the latest contribution. As I read it, the key message is that the fall in the participation ratio over the last few years paints an inaccurate picture of labour market slackness thanks to the way the US calculates the participation ratio. In most countries, the calculation is approximately employed + unemployed as a proportion of those of working aged – ie, aged 15-64. But in the US, the calculation is employed + unemployed as a proportion of all those aged over 15 years. So, naturally enough, as more people move into retirement, the US count of labour participation will fall. However, if you take the more accepted 15-64 participation ratio, you'll find that it has been rising quite steeply over the last few years.  In fact, the US labour participation ratio is not around 63% as claimed, but rather is slightly above 69%.  Smithers conclusion? There is less slack in labour markets than you might think, which means a) that the potential growth rate is commensurately lower and b) wage inflation will emerge sooner than you think. From which we must conclude that the Fed's room for sustained easing is less than we think – so sell bonds. 

Instinctively, or perhaps even ideologically, I'm sceptical, because: 

1. I'm convinced there must be a large cyclical element in the recent decline in the US participation ratio, which might be glossed as a large number of people reassessing what they want out of their lives in the wake of the financial crash;  
2. I see no good reason to hold on to the notion that people in non-labour-intensive employment will want to retire aged 65.  Take Mr Smithers, for example: I don't know how old he is, but if he joined SG Warburg in 1962, then it's a safe bet that he's a distinguished living exemplar of this point. The view of the inevitability, or desirability, of retirement aged 65 should be recognized as an extremely rare exception in any culture at any time, and one which there is no good a priori reason to expect to endure. If you doubt me, read Dickens.
3. I believe the essence of economics and economic growth is improvisation. This is why Goodhart's law is so crucial to any working economist, and more generally why one should always be sceptical of 'the economic data' (since by definition, it is measuring activities which are already superseded, or are in the process of being superseded).  In the case of demographics and labour markets,  we'll probably discover that the 'inevitability of demographics' turns out to be neither particularly inevitable nor specifically predictable.  Or put it another way: old age isn't going to be what it used to be.

Those are my prejudices, and, of course, they may be wrong.  But let's look at the experience of the country with the longest history of responding to an aging population:  Japan.  It is worth running Mr Smithers' charts for Japan over the long term to see how various measurements of labour participation have changed over time. 

First, let's have a look at the underlying demographic change – in particular, the rise of those aged 65+. This has been dramatic, rising steadily from 8.9% in 1980 to 25% in 2013. This compares to an US rate estimated at 13.7% in 2012. Not only is Japan's total elderly population greater, it also grew more rapidly, averaging a rise of around 0.6% of the population per year during the last 20 years, which is approximately double the rate at which the proportion of similarly-aged Americans is rising. 

Given this far more dramatic demographic aging, it surely should be expected that we would see commensurately more dramatic twists and turns in Japan's labour participation rates, on both bases of calculation, than we are seeing in the US currently. If, that is, the current fluctuations are indeed a product primarily of demographic change. 

The chart below measures changes in the labour participation ratio on both the 15-65 measure and the 15 and above measure. 

As one would expect, the shape is similar to what one sees currently in the US:  labour participation rises on the Aged 15+ count, but has fallen on the Aged 15-65 count. But it is not the similarities which are important, but the differences.  First, the decline in the Aged 15+ count is far less dramatic than one sees currently in the US, even though the aging was more rapid. The peak of participation on this count was in 1992, at 63.9% when the those aged 15+ accounted for only 13% of the population.  Since then it has declined by only 4.6 percentage points to 59.3%, even though the proportion of the population aged 15+ jumped 12 percentage points to 25%.  By contrast, the US participation rate fell from 63.4% to a low of 58.2%  - a fall of 5.2 percentage points -  between 2007 and 2010.  

Both the size of the fall, and its speed, are unlike anything seen in Japan.  It's too much, and much too fast.

The second point is that Japan's experience places a huge question-mark over whether it is reasonable to accept 65 as a relevant age to start counting retirees.  After all, the participation rate calculated against a labour force of those aged 15-65 has now risen to no less than 83% currently in Japan, whilst on Mr Smithers' calculations,  on the same base of calculation, the US has yet to hit 70%.  The opportunity for extended working lives clearly has been grasped strongly in Japan, and if the US is anything like similar, there is simply no reason to believe that current levels of participation are anywhere near a ceiling. 

Finally,  Mr Smithers' conclusions about the  possible impact on labour market pressures of a higher-than-advertised participation ratio also finds no support from Japan's experience. At the same time as corporate Japan has evidently employed ever greater numbers of 'retired' workers, so it has persistently reported an oversupply of labour, and wage inflation has been almost completely absent. 

This is not to say that Mr Smithers will ultimately be wrong: he has long argued that the upper limit on Japanese labour numbers provides a tight constraint on Japan's GDP growth, since it simply is not possible to substitute capital for labour without accepting ever-diminishing rates of return.  And so far, the overall evidence from Japan bears him out. 

But in the case of the US right now, the evidence he provides is not strong enough to support strong conclusions. Demographics probably aren't the overwhelming factor in the recent decline in US labour participation ratios; there's no reason to believe that the 'real participation rate' is approaching a ceiling; and there's every reason to believe that improvisation will trump demographics in US labour markets for the foreseeable future. 

Japan: Capacity Constraints vs Expectations

It has been a grim week for Japanese industrial data: industrial output fell 2.3% mom in February, and the fall in the March JMMA/Markit manufacturing to 53.9, the most modest expansion since Sept 2013 hardly suggests a rapid rebound. Trade data for the first 10 days of March tells the same story (with exports up just 3.1% yoy in yen terms). These can perhaps be dismissed as showing transient weakness, possibly anticipating a collapse in demand because of the the 3pp rise in consumption taxes which took place this week.

The point of BOJ's quarterly Tankan surveys is to capture slightly longer-term trends. But the 1Q Tankan was also disappointing, with the Large Manufacturer's outlook index falling to just 8, which is the weakest for a year and which was a quite dramatic fall from the +17 recorded for current conditions. Even worse, the all-industry capex forecasts collapsed to 0.1% yoy for the coming year.

However, hidden away in the details was more encouraging news which raises the economy's chances of surfing through the cross-currents caused by the tax rises. Specifically:

• the diffusion indexes tracking supply-side constraints continue to suggest the potential for positive cyclical pressures. Large companies' readings of excessive employment minus insufficient employment came in at minus 6 (+2 for manufacturers, minus 12 for non-manufacturers); and this is forecast to improve over the next three months to minus 4 (+4 for manufacturers, minus 12 for non-manufacturers). 
• the diffusion index for excessive production capacity minus insufficient capacity came in at +2 (+6 for manufacturers, minus 3 for non-manufacturers), and this also is forecast to tighten over the next three months to +1 (+6 for manufacturers, and minus 3 for non-manufacturers). 

It's worth putting those in context: since 1995 the tightest reading for the employment diffusion index was minus 13 at the end of 2007, whilst the average has been +10.7. For production capacity, the best reading since 1995 was minus 2 – again in 2007 – whilst the average has been +9. So among the messages of the 1Q Tankan was this: Japan still has a (very slight) labour shortage, and no longer has a significant production capacity overhang.

 

Now this assessment is strikingly similar to the views underlying Bank of Japan's calculation of Japan's output gap (the difference between actual GDP and potential GDP).  BOJ's view that Japan is likely to close its deflationary output gap in the short to medium term looks plausible: quite possibly by the end of this year, Japan's domestic economy will supply insufficient  goods and services to meet domestic demand. (Incidentally,  the emergence of a sizeable current account deficit also suggests a domestic economy which is becoming cyclically, if not yet structurally, undersupplied.) If so, this would be the first time since before the financial crisis, and potentially for only the second sustained period since 1990. 

I have stolen the chart below from Bank of Japan's Outlook report published in October 2013, partly because it so closely echoes the Tankan findings, but mainly because it shows how distant is the memory of Japan being supply-constrained. 

In practice, expectations entrenched over such a long time are unlikely to be overturned simply because the facts change. The process of changing expectations sufficiently to alter economic, commercial and financial behaviour is likely to be long and frustrating – the initial 'shock-value' of Abenomics was prized at first specifically on the hope that it might short-circuit this process of expectation-rebuilding.   That 'shock-value'  might not have dissipated entirely without result: that, perhaps, was the  underlying message from March's Shoko Chukin SME confidence index hitting the highest point since 1989.  

Nevertheless, as a guide to what we might expect, it seems realistic to take as our baseline what happened in that period between roughly 2006 and mid-2008 when large companies thought they had insufficient production capacity, and unsufficient labour. What happened to: company capital spending; labour markets; and inflation? 

Capital Spending Using the MOF's quarterly survey of private sector balance sheets & p&ls as our guide, there was a vigorous response to the threat and then emergence of a shortage of capital stock during this period.  Following years of negligible growth or actual shrinkage in spending on plant and equipment, as supply constraints began to emerge, spending rose 9.6% in 2004, 8.5% in 2005 and  14.7% in 2006 before being choked off in 2007 and subsequently.  It hasn't recovered: corporate spending on plant and equipment last year was a mere 68% of what it had been in 2007!  

On the basis of the tightening supply-side constraint on productive capacity, it seems reasonable to expect that the dire 0.1% yoy forecast of capex spending will be revised sharply higher in the coming quarters. 

Labour Markets This strength did not carry through noticeably to labour markets, however.  There was a stabilization in employment, but growth never got much above 0.6% yoy during the years of undersupply, and there was no noticeable or significant rise in wages. Rather, these were precisely the years when companies managed to push up the sales/expenses multiples of employees to highs of around 8.3x previously seen only in the immediate aftermath of the bubble years.  In short, employers reacted to a perceived shortage of labour by raising the productivity of their employees and booking the profits.  The moral is that it will take more than the perception of labour shortages to push up wages sharply. Not only is there no sign that this is taking place now, there is little reason to expect it to arrive any time soon. 

Inflation and Inflationary Expectations Finally, it is worth querying something that seems obvious – that the short bout of supply-side constraints did very little to move inflationary expectations, or, indeed to significantly mitigate deflationary tendencies in Japan. True, the CPI's downward drift was not significantly interrupted. However, there were signs that at the corporate level, there was a scaling back of deflationary expectations. Specifically, during 2006 to 2008, 15+ years of sharp corporate deleveraging, measured either by total assets/ equity, or by net debt/equity were both halted, and replaced by a short-lived bout of mild re-leveraging!  Although mild, this was also unprecedented in post-bubble corporate Japan: it almost amounts to a rush of blood to the head.

Conclusions?    Looking past the weakness of current data, and the likelihood that the tax rises will produce more such data in the short term, it does look as if for only the second time since the bubble years, Japan is hitting genuine supply-side constraints.  On the positive side, this forms a genuinely encouraging background for a capital spending cycle in a way which defies the current dire data. Quite possibly, it will also see a reversal in long-standing develeraging behaviour by corporate Japan. But the hopes that the cycle will be driven by gains in labour markets, specifically through significant wage rises, are unlikely to be realised.