The crystal-ball gazers at McKinsey & Co. aren't known for pessimism. Whether the topic is U.S. productivity, the future of capital markets, offshoring, or the rise of China, the McKinsey view of the future is almost always upbeat.
It's surprising, then, that a hefty new study by the consulting firm's economic think tank, the McKinsey Global Institute, is so downbeat on the shape of global finance in the coming decades. The reason: The rapid aging of the world's population -- especially in rich nations like the U.S., Europe, and Japan that now possess the lion's share of international capital (see BW, 1/31/04, "Global Aging").
The study is titled The Coming Demographic Deficit: How Aging Populations will Reduce Global Savings, and it was completed just in time for the Jan. 26-30 World Economic Forum in Davos, Switzerland. It projects that due to demographic changes, industrialized nations' annual growth in financial wealth will have slowed by two-thirds by 2025, from a historical average of 4.5% to just 1.3% a year.
NO EASY REMEDY. That slowdown will translate into $31 trillion less global wealth than if the world's median age had remained the same as it is now (36 in the U.S., 38 in France, and 42 in Japan). "If unchecked," the report concludes, "this shortfall could significantly reduce future economic well-being and exacerbate the challenge of funding the retirement and health-care needs of an aging population."
McKinsey sees no easy remedy to filling this projected shortfall. Higher productivity growth, pension reform, a later retirement age, and more immigration will not be enough to offset the impact of shifting demographics. Also needed are measures to encourage sharply higher savings rates and better financial returns on those savings.
McKinsey Global Director Diana Farrell explained the reports findings and implications to BusinessWeek Senior Writer Pete Engardio. Following are edited excerpts from their conversation:
Q: The trends of declining fertility and longer life spans are well known. And aging's full impact won't be felt for decades. Why focus on this now?
A: Here's the main reason: Through our work with focus groups, we've learned that when people make assumptions about the future, they're not fully taking demographics into account. If you ask people who are 55 now whether they can maintain their standard of living for the rest of their life, they say they can. But that's only because they think their life expectancy is about 70. Actually, it's much longer than that.
Q: What are the implications of your projections?
A: First, our report suggests that what we regard as standard, status-quo growth rates won't apply anymore. Most importantly, the pressure to achieve underlying growth through productivity is only getting greater. We also need to encourage higher savings rates among individuals, and we need to make the financial intermediary process as efficient as possible so that capital can be put to better use. The U.S. has an extremely efficient capital-allocation process that puts what little savings we do have to good use. But that's not the case everywhere in the world.
Q: Most of these studies assume low productivity growth for the U.S. -- about 1.5% a year. But in recent years, U.S. productivity has been more in the range of 2.5%. If you factor in higher productivity, does that solve the problem?
A: Achieving higher rates of productivity would certainly help. But to solve the problem we would need numbers way north of what we can reasonably expect. For example, our institute thinks U.S. productivity can keep growing at 2.6%. But we would need to double that to offset the effect of demographics.
Also, we would need to assume that higher productivity would translate into higher savings rates. In the 1990s, however, this didn't happen. So history suggests that even if we achieve really extraordinary increases in productivity, it doesn't necessarily eliminate the problem.
Q: If capital will be more scarce in the future, do you fear a big drop in the value of real estate, stocks, and retirees' nest eggs?
A: It's a very complicated story. Many people have predicted massive drops in real estate prices. But the impact of demographics on asset prices is very hard to predict. People who take a very long-term view on asset returns are likely to be wrong because there are too many factors at play.
Q: Countries like China and India are growing dramatically. Won't they be able to make up for any global capital shortfalls and keep U.S. asset prices high decades from now?
A: When people talk about the enormous economic power of China, they really are looking at it from a purchasing power point of view. [That's a way to compensate for different currency values by looking not just at per-capita economic output, but at what an individual can purchase with that amount of money. For example, China's per-capita gross domestic product is $1,250. But the purchasing power of that money is roughly four times as high.] For purposes of thinking about global savings, the only way to reasonably think about it is on an exchange-rate basis, because U.S. assets are in U.S. dollars.
Even if China maintains the extraordinary rates of growth of the past few decades, it would take 18 years to reach the wealth level of Japan now. That means uninterrupted, 10%-a-year growth. There's no reasonable case that China will have the wealth to make up for the economic effects of aging in the West and in Japan. And, of course, China is also a rapidly aging society. They could change the one-child policy. But even if they did that today, those new children wouldn't enter the workforce for 20 years.
Q: What about India?
A: India is very interesting. But it plays a small role in world finance, accounting for just 1% of global capital stock. True, it's growing at 11% a year. But even if it continues growing at that rate, it still won't make up more than a few percentage points of world capital.
Q: So what can countries do to at least maintain current living standards in the future?
A: The response to this won't be easy because any one of the adjustments that take place will have to be of a very large magnitude. And each one is very hard to implement. It will end up being a combination of solutions. But they will be very serious adjustments, not marginal ones, and will require creative thinking.
Increasing the retirement age is a no-brainer. So is increasing contributions to retirement plans at the same time. These are legislative changes. But at the end of the day, we also have to increase household savings rates and returns on those savings. This will be essential.
Q: Are there some countries where it's just hard to be optimistic about the ability to maintain today's living standards?
A: It's hard to see a scenario that has Japan keeping the same level of overall wealth going forward 20 years. Some European economies also face major challenges. As for the U.S., lots of changes and adjustments would be required, but you can see a scenario in which these changes would occur.