• I don’t think the key issue in the debate over Social Security is whether, over the next century, the risk-free return will be 1 or 3 percent, or whether the equity premium will be 3 or 5 percent. So even if I agreed with the arguments raised in this paper and lowered my estimates of rates of return, it would not change my mind about the need to reform Social Security or the kinds of reforms that are desirable.

I would guess that, in their hearts, the authors of this paper agree with me about this. To see if I am right, I would like them to answer the following question: Suppose that next week, the stock market falls by 50 percent, so dividend and earnings yields double. Would Baker, DeLong, and Krugman suddenly be in favor of President Bush’s proposal for Social Security reform? I suspect they would not. If I am right, this suggests that while the paper raises some interesting questions about the future of assets returns, as far as the debate over Social Security goes, it is largely a non sequitur.

• Let me turn now to...the equity premium. Here the authors give us a model that is, in some way, the strangest contribution to the equity premium literature I have seen... [it] can be viewed as creative, bizarre, or vacuous, depending on your point of view... Most analysis of the equity premium begins with the premise that it has something to do with the tradeoff between risk and return. Not so, in this model. Here, the household sector decides exogenously what fraction of wealth to put in equities, and the corporate sector decides exogenously what fraction of the capital return to pay out to equity holders. From these two exogenously determined shares, the equity premium emerges.

The model reminds me of John Kenneth Galbraith’s view of the world. Households are not sufficiently intelligent to make portfolio decisions based on risk and return. Corporate managers are sufficiently immune to market forces that they divide up the economic pie however they see fit. If I took this model seriously, it would do more than inform my view of the equity premium. It would shake my faith in corporate capitalism!

• ...this paper discusses the expected return on the stock market using the famous Gordon formula, according to which the expected return on a share of stock equals the current dividend yield plus the projected growth rate of dividends per share.

Although the Gordon formula has a long and venerable tradition, I don’t think it’s provides a particularly edifying approach here. For a neoclassical economist, the starting point for thinking about the role of dividends in stock valuation is the classic Modigliani-Miller theorems, which tell us that the dividend payout is irrelevant to the value of the firm. It seems unnatural at best to start an analysis of stock valuation focusing on the level and growth of a variable that, to a first approximation, does not matter.

• Is it possible, they ask, for the growth in dividends to significantly exceed growth in the domestic economy because corporations are investing and earning profits abroad? They suggest that this possibility is unlikely because (they claim) it would require current account surpluses so large as to be historically anomalous.

I must confess that I just do not follow the logic here... Here is one scenario that seems plausible to me. With the rest of the world, such as China and India, growing so rapidly, U.S. companies will increasingly find profitable opportunities abroad. At the same time, foreigners will increasingly invest in U.S. companies, which will be among the driving forces behind global growth. Under this scenario, an increasing share of the earnings of U.S. corporations could come from abroad, without any obvious implications for the U.S. current account.

• In the end, I think it is clear that the tools of modern growth theory lead to an ambiguous answer about how population growth affects the return to capital. You can write down textbook models in which the two variables move together (the Solow model), and you can write down models in which they do not (the Ramsey model). The natural response to this theoretical ambiguity is to muster evidence, either from time-series data or from the international cross-section, about the actual effect of population growth. This paper, however, presents no evidence one way or the other. Perhaps that is a subject for a future Brookings paper.

• First, Glass reminds us that the 5% stock market returns predicted by the "paper" trounce the internal rate of return of Social Security itself.
• Second, Glass notes that if poor economic growth hurts stock returns it will also hurt bond returns -- which will make the solvency problems in Social Security far worse.
• Third, Glass notes that while Baker, DeLong and Krugman fret about lower stock returns if growth is poor, they are actually forecasting that growth will not be poor.
• Fourth, Glass refutes the argument that personal accounts will be unnecessary to assure solvency under conditions of good economic growth -- on the grounds that personal accounts are not being advocated for purposes of solvency, anyway!
• Finally, here's Glass's wrap-up:

Now, summing up -- and with the larger perspective of the benefits that private accounts are meant to provide -- let's look at the logical consequences of the DeLong/Krugman/Dean [Baker] proposition for Social Security reform:

Economic growth -- and with it the financial return to assets such as stocks and bonds -- will in the future either slow or not slow...

* If economic growth does not slow but continues at the rate of the past, so stock returns stay high, then the solvency problem of the Social Security status quo goes away and the status quo can be easily afforded, so says Krugman.

But private accounts are neutral as to the solvency of Social Security. So if the status quo can be easily afforded, then private accounts can be equally easily afforded!

And they will pay high investment returns, as in the past -- compared to the minimal-to-negative returns from Social Security.

If a reform will improve the welfare of Social Security participants by increasing the return on their Social Security contributions from negative to the positive, plus by giving them the benefits of asset ownership ... and it will improve the welfare of nation as a whole through an increase national savings ... and it can be easily afforded ... then what argument is there against it?

* If economic growth does slow, so that asset returns will be lower in the future than than the past, and lower than the Social Security actuaries project, then the current value of the future unfunded liabilities of Social Security is much larger than currently projected -- perhaps twice as large, or more than twice as large.

In that case, the fiscal problems of Social Security are much worse than even pessimists say today -- and the case for reform to address much the larger funding gap soon (and also to secure benefits being earned today from future fiscal pressure) becomes that much more urgent.

Either way, take your choice, it's an argument for Social Security reform.

Catch-22.

Well, that's how it looks to me. What do you think?
 

What makes him loathsome is the perverse ideological calculus of his career arc, which represents a common Hogarthian progression among right-thinking, politically astute New York progressives: Spend your 20s shaking fists, spend your 50s licking boots. In his day job, Carter edits a magazine whose unabashed purpose is to make icons out of idiots; then, in his spare time, he turns around and wonders aloud for 300 earnest pages (that What We've Lost anti-Bush thing you saw sticking like a fridge magnet to the pile of Al Franken books at Barnes & Noble) how it could possibly have happened that America elected a dolt like George W. Bush. This is the business of the educated New York media creature with a society profile: Laugh at middle America for declaring itself a maggot for Jesus, but at the same time commission Annie Leibovitz to shoot Brad Pitt in the pose of Zeus or the angel Gabriel. At least Republicans only drop to their knees for God.

But of course the real purpose here is just to give the media more anti-modernization stuff to cover for another news cycle. And obligingly, the New York Times is there, with a story today by the politically reliable Edmund Andrews, rounding up opinion of diverse economists that future returns for the stock market will be lower than past returns (which isn't even anything that the Baker, DeLong and Krugman "paper" claims). Since 1926, the annual real total return for the S&P 500 has been 7.2% (according to Ibbotson Associates). The Social Security actuaries predict only 6.5%. The Times claims a "growing number of economists" feel that stocks will perform more poorly in the future, but can come up with but a single one willing to put a number on it -- the politically reliable Goldman Sachs, who ventures 5%.

But even 5% would handily beat the 3% hurdle rate that a Social Security participant would have to overcome if he voluntarily elected a personal account. 3% is the implied rate of the "benefit offset" that such people would trade in exchange for the potential higher growth of a personal account. Of course the Times calls that voluntary benefit offset "automatic cuts in traditional Social Security benefits."

Posted by Donald L. Luskin at 1:52 AM | link    

Wednesday, March 30, 2005