Demographics and Unemployment Málstofa í Seðlabanka Íslands 9. desember 2002 Tryggvi Thor Herbertsson IoES, University of Iceland Edmund S. Phelps Columbia University Gylfi Zoega Birkbeck College, University of London

Introduction Current research aims at explaining decade-to-decade movements in average unemployment as well as cross-country variation. A consensus appears to be emerging on the importance of the interaction between shocks and unemployment but less so on the nature of the shocks. Potential shocks include: –changes in the rate of productivity growth (Pissarides, 1990, 2000; Hoon and Phelps, 1997), –skill-biased technological progress (Wood, 1994; Nickell, 1996), –the world real interest rate (Phelps, 1994; Blanchard and Wolfers, 2000, Nickell, 1999), –the price of energy (Bruno and Sachs, 1986; Oswald, 1999), –changes in share of profits (Blanchard and Wolfers, 2000) –the state of stock market (Phelps, 1999; Fitoussi, Jestaz, Phelps, and Zoega, 2000).

Introduction The literature has paid surprisingly little attention to demographic factors, in particular changes in the age structure of the population. Shimer (1999) is a novel exception. This paper investigates some possible channels through which a changing age-structure might affect unemployment, in particular: –Compositional effects: When the cohorts suffer different unemployment rates, their relative size affects the aggregate unemployment rate and labor force participation. –Macroeconomic shocks: The origins. Generations differ in their saving propensities and possibly creativity, as innovations may come more frequently at certain stages in life. Thus both investment opportunities and the supply of available savings may depend on the age distribution of the population. Responsiveness. When an adverse shock hits the economy, the responsiveness of unemployment depends on labor-market institutions such as the duration and level of unemployment benefits and the organization of labor unions. However, demographics can play a role that has so far not received much attention.

Demographic Structure The share of prime-aged workers in the total population (defined as the year old/total population ratio) in the G7

Age-structure and Unemployment

Compositional Effects When the cohorts suffer different unemployment rates, their relative size affects the aggregate unemployment rate and labor force participation.

Compositional Effects Unemployment differs substantially between cohorts (OECD).

Compositional Effects Differences in unemployment across cohorts can to some degree be traced to differences in the level of non-wage income. This has many sources: –Accumulated savings in the form of real wealth are normally monotonically rising in age. –The income of a spouse increases with age so this form of non-wage income is also rising in age. –The cost of raising children, which initially rises in their age and then falls. As a result, non-wage income falls initially and then rises again as the children leave the nest. –Parental support, which is declining in age. –The expected present value of anticipated inheritance which is rising in one’s own age (becoming less important due to annuitization of wealth). –Social spending such as health care, public education for children, minimum income support, state pension, etc. is often an important form of non-wage income and depends on age.

Compositional Effects For the calculation we define: u i as the unemployment rate in group i u as the aggregate unemployment rate L i as the number of people in group i L as the total number of people in the labor force Furthermore, we define v i = L i /L, Then by definition: We get the unemployment rate adjusted for demographic changes by using initial weights:

Compositional Effects The age-group-unemployment pattern is remarkably stable (G6):

Compositional Effects Unemployment would have been 50 basis points lower in 1998 in the OECD if the demographic structure had remained the same as in 1965.

Participation Rates –Unemployment is only one side of the coin. –Changing age structures may also be reflected in changing labor- force participation rather than unemployment. –In 13 OECD countries, the average labor force participation of year-old males fell by more than 12 percentage points between 1979 and –The participation rate increased by approximately 5 percentage point for females, resulting in an overall average drop in OECD labor force participation of almost 3 percentage points, cf. Herbertsson and Orszag (2001).

Participation Rates

Participation would have fallen by more if the baby-boom generation had not come of age!

Macroeconomic Shocks: The Origins Generations differ in their saving propensities and possibly creativity, as innovations may come more frequently at certain stages in life. Thus both investment opportunities and the supply of available savings may depend on the age distribution of the population and thus create structural booms as well as slumps.

Macroeconomic Shocks: The Origins National savings depend on the age distribution (life-cycle hypothesis). With perfect capital mobility a changing (global) age distribution would affect the world interest rate. Some recent NAIRU models that treat labor as a (quasi) fixed asset suggest an important role for the world interest rate. The sign of this effect goes contrary to that implied by the Mundell-Fleming analysis. (age up -> savings up -> investment up -> investment in humans up -> returns up)

Macroeconomic Shocks: The Origins Feldstein and Horioka have shown that savings and investment are highly correlated. If hiring has an investment dimension we would also expect investment in hiring and training of new workers to move with the aggregate saving rate.

Macroeconomic Shocks: The Origins Recent structural booms (the “new economy”?) can be traced to innovations and creativity of entrepreneurs. Here, the age distribution may come into play. Casual observation suggests that people may be most creative in their thirties and early forties (with greatest potential of turning ideas into reality). A relatively young population would then have proportionately greater number of entrepreneurs than an older one and hence a faster rate of expected productivity growth and a higher-valued stock market. This may induce firms to step up their hiring, driving down the unemployment rate.

Macroeconomic Shocks: The Origins The relationship between the the rise in the stock market (nomalized by labor productivity) and the number of people between the ages of 25 and 34 in 1990 (relative to the number in 1960 in left-hand panel and the current population in the right-hand panel)

Macroeconomic Shocks: Responses When an adverse shock hits the economy, the responsiveness of unemployment depends on labor-market institutions such as the duration and level of unemployment benefits and the organisation of labor unions, but also on the age-structure.

Macroeconomic Shocks: Responses The interaction of institutions and macroeconomic shocks plays a key role in the emerging consensus on the determination of medium-term unemployment, (Blanchard and Wolfers, 2000). Thus certain institutions are likely to mitigate the effect of shocks while others exacerbate them. The data appear to suggest that shocks have more serious consequences when: –the unemployment benefit replacement ratio is high, –the duration of such benefits is long, –there is employment-protection legislation, –there is a lack of co-ordination among unions and employers, –a low level of active labor-market spending such as retraining and placement schemes.

Macroeconomic Shocks: Responses How can the age distribution affect the sensitivity of aggregate employment to macroeconomic shocks? –Job security is rising in tenure and hence, ceteris paribus, in age. Since it is more difficult to dismiss an old worker, the sensitivity of employment to shocks should be a decreasing function of the size of the older cohorts. –Similarly, the age structure and the institutional framework may interact in affecting employment. Thus employment-protection legislation may be more effective for the older is the average worker. (However, firms may opt for early retirement instead of dismissals which would cause the effect to show up in labor-force participation instead of unemployment.) –A transitory shock is more likely to lead to the dismissal of an older worker because of his shorter expected post-recession tenure. Thus the level of labor hoarding may be smaller for the older workers due to their shorter remaining worklife. This would make the sensitivity to shocks greater.

Macroeconomic Shocks: Responses  Older workers may find it more difficult to find another job as their remaining tenure is shorter. They are thus more likely to become long- term unemployed. As a result, the higher is the proportion of older workers in the labor force the more likely is a transitory shock to employment to have a persistent effect on employment.  Older workers may be more resistant to real wage moderation as their accumulated wealth reduces the dependence on employment. This raises the possibility that real-wage cuts are less likely the higher the proportion of older workers.  What due the data say (rational: Fitoussi, Jestaz, Phelps, and Zoega, 2000)

Macroeconomic Shocks: Responses

The sensitivity to macroeconomic shocks and the proportion of labor force between years

Conclusions The paper does not spell out any deep consistent theorems, rather it aims at investigating various sources through which changing age-structures might affect unemployment. To conclude: –We have found that the compositional effect of demographic changes do not account for the big swings in unemployment observed in many of the OECD countries. –Looking at the OECD as a whole, only current unemployment is only 50 basis points lower than it would be if the age distribution of the labor force were the same as in the sixties. –However, the effect varies somewhat between countries with France showing the biggest effect of 140 basis points. –A changing age structure is reflected more strongly in lower participation rates than in unemployment. –We find that if it were not for the aging of the baby-boom generation participation rates would have fallen by more than observed.

Conclusions –We also looked for the effect of age distribution on the origins and responses to macroeconomic shocks. –We found a surprising (time-series) correlation between world real interest rates and the share of workers over 55 years of age in the OECD. –We also found a strong (cross-sectional) correlation between the share of workers between 25 and 34 and the rise in the stock market from 1990 to –On both counts we might expect a relationship between the age distribution – either locally or globally – and national unemployment rates. –Finally, we found that the sensitivity of unemployment to macroeconomic shocks depends negatively on the share of the young in the population possibly due to labor hoarding when we also take into account various labor market institutions. A relatively young population suffers less unemployment for given shocks. General conclusion: – When analysing unemployment, investigating demographics is a path worth taking!