Will China Eat Our Lunch or Take Us to Dinner? Simulating the Transition Paths of the U.S., E.U., Japan, and China

Abstract

This paper develops a dynamic, life-cycle, general equilibrium model to study the interdependent demographic, fiscal, and economic transition paths of China, Japan, the U.S., and the EU. Each of these countries/regions is entering a period of rapid and significant aging that will require major fiscal adjustments. But the aging of these societies may be a cloud with a silver lining coming, in this case, in the form of capital deepening that will raise real wages. China eventually becomes the world’s saver and, thereby, the developed world’s savoir with respect to its long-run supply of capital and long-run general equilibrium prospects. And, rather than seeing the real wage per unit of human capital fall, the West and Japan see it rise by one fifth percent by 2030 and by three fifths by 2100. Even if the Chinese saving behavior gradually approaches that of Americans, developed world real wages per unit of human capital are roughly 17 percent higher in 2030 and 4 percent higher at the end of the century. Without China they’d be only 2 percent higher in 2030 and 4 percent lower at Century’s end. The short-run outflow of capital to China is met with a commensurate short-run reduction in developed world labor supply, leaving the short-run ratio of physical capital to human capital, on which wages positively depend, actually somewhat higher than would otherwise be the case. On the other hand, our findings about the developed world’s fiscal condition are quite troubling. Even under the most favorable macroeconomic scenario, tax rates will rise dramatically over time in the developed world to pay baby boomers their governmentpromised pension and health benefits. As Argentina has so recently shown, countries can grow quite well for years even with unsustainable fiscal policies. But if they wait too long to address those policies, the financial markets will do it for them, with often quite ruinous consequences.