One thing that you really haven't addressed is the fact that the 7% return assumes a continuation of the excess returns on stocks. But if SS privitization does cure this problem of poor capital allocation the excess premium would go away. All you would be left with is a return that reflects the additional risk and so a real return more along the lines of 4-5% would be expected anyway. So while the economy as a whole would be better off, no (representative) individual would be after accounting for risk (yes those who are more risk loving will still benefit but they are just like those who receive consumer surplus by buying below what they value a product at).

Brad wrote:

"You could argue--unconvincingly--that even though accounting earnings have been a good guide to true earnings in the past, they are massively understating earnings today."

Not such an outlandish argument at all. In the era when the US economy was driven by large manufacturing companies competing in relatively stable industries, relying on capital bases composed largely of physical plant assetts, GAAP were reasonably good at reflecting economic reality. US Steel spends $100M building a blast furnace, and gets to depreciate it over its useful life of 50 years, with earnings marked down $2M per year.

In an era when the economy is driven by services and technology companies competing in rapidly changing industries, relying on "capital" bases composed largely of things like intellectual and organizational capital, GAAP, as currently constituted, does a very poor job of reflecting economic reality. PharmaCo spends $100M on proteonomics R&D, but since it can't be capitalized under GAAP, has to take a $100M hit to earnings today.

Speaking of stock returns:

http://tinyurl.com/6f5ah

Richard A. Grasso, the former chairman of the New York Stock Exchange, received $144 million to $156 million in excess compensation during his time at the Big Board, taking deliberate steps to keep his high-profile board in the dark about his soaring pay and get the money out early, according to a stinging internal report released today by the exchange.

I suppose we could imagine a continued 7% yield if that 4% number has to do with earnings being understated. But most corporate scandals lately have earnings overstated. (Also, sheltering earnings worth 3% of total market capitalization would be a pretty massive tax fraud, right?)

Why are the models all using growth rates from the US rather than the planetary economy?

The money which will hopefully pay my pension is invested on the assumption that Eastern Europe will come to resemble contemporary Germany, and that China will be for the next twenty years wanting commodities to about the limit of the planet's production; it's in Comercni Bank of Prague, BHP Billiton, Argentine pampas beef producers, that kind of thing.

What I don't know is what proportion of world equities the US market contributes; there's not enough equity in Magyar Olaj- es Gazi-pare Resvenytar to accumulate even a very small proportion of the social security fund.

Having Americans obliged, in search of life-sustaining returns, to invest trillions of dollars in what are currently capital-starved economies is perhaps as good a way as any to get the 7% planetary growth rate which leaves the poorest people on Earth as rich as the 2005 USA by 2070.

Auros wrote:

"Also, sheltering earnings worth 3% of total market capitalization would be a pretty massive tax fraud, right?"

Absolutely not. The financial statements that public companies prepare to comply with the public disclosure requirements of the SEC (so-called "accounting earnings") are prepared under entirely different rules from the financial statements prepared for the IRS (so-called "tax earnings"). The stock market, to the extent that it is efficient (and for the most part it is), cares about "economic earnings," which can differ systematically from both accounting and tax earnings. Variance from accounting earnings is caused by weaknesses in Generally Accepted Accounting Principles (GAAP). Variance from tax earnings is caused by the host of distortions in the tax code caused by rent-seeking lobbyists.

Jim (who I believe is Scrivener, yes), over in the Vox Baby thread, has stated: "I note that the S&P 500 over the past 55 years to 1/1/05 has appreciated 0.9% a year on average faster than GDP."

So, if growth of GDP has been 3%, that would imply that the capital gains portion of stock returns was 3.9%, with a dividends return rate of 4.5% (reasonable by Shiller's standards, right?) adding up to the 8.4% Brad has above.

Am I understanding the model correctly?

"I suppose we could imagine a continued 7% yield if that 4% number has to do with earnings being understated."

Now if IBM and GE back out their pension profits, I mean theft, what are their true earnings?

Sorry Louie and Jack, I put you in the Enron category, not the pedestal you think you are on.

Assume that the Bush Jr. Jublilee will remove the debt portion of the cost of doing business and American stock markets will price that into the stock quote. Presto, we get a very good return from private accounts invested in stocks and a very bad return on the social security trust fund, which, last I heard, was invested in treasury bills and bonds and whatnot. You know, dollars.
We have a lot of debt as a country and a population. Some we owe to the upper twenty percent, some we owe to the rest of the world. That debt will go away very soon, as soon as people stop lending us money and we go bankrupt as a country. This has stock market implications. Also social security trust fund and tax rate implications.
On the other hand, maybe the rest of the world will continue lending us two weeks pay every year. Could happen, right?

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even the most pessimistic predictions about peak oil place the peak long before all of this social security nonsense comes into play.

how will the economy of the world grow without the cheap energy that caused this population to be sustainable?

madness...

I believe the .9% in 55 years is mainly attributed to a rise in price to earnings ratio.

[Yep.]

If you do the same calculation back to the mid 1970s, you'll find we've had a 2.7% per year tailwind from increasing P/E.

Presumably, it would be possible to have P/E once again hit the eight to ten range from the 1970s at some times during the next 75 years. If so, you'd see valuations collapse by a considerably more than half.

That wouldn't be too bad if earnings go by more than 2X before then. But we're arguably near the top end of earnings as a fraction of GDP now, and companies are having a hard time figuring out what to do with capital, which has been sitting in money market funds.

Even with the cut in dividend tax rate, the dividend payout ratio hasn't gone up noticably. We've had a big recovery of earnings since the collapse in 2002 and a comparatively small change in dividend payouts. So, companies don't know what to do with funds, but they're still not paying a whole lot more out.

Why are they sitting on the money, $30 Billion one-time payouts for lack of growth or acquisition opportunities notwithstanding?

Is that 8.39% nominal or real?

[Real]

Because if that's a nominal figure, it's trouble. Assume (optimistically!) that inflation averages 2%. Real yield is 6.39%. Now remember that the first 3% of your returns are clawed back against your benefits. Figure management costs of 1% (optimistic again).....and we get some 2.39% yield.

That wouldn't beat cash on deposit.

''from 1871 to 2003, the average one-year-ahead real return on stocks--the Cowles index linked to the S&P Composite--averaged 8.39% per year.''

Did the USA have any standard unit of currency by which to measure performance prior to the establishment of the Federal Reserve in 1912?

In 1900, $20000/year would have bought you everything that money could buy, including servants. How does the availability of more spending opportunities today devalue today's returns? A dollar today doesn't yield the same amount of differentiation it once did, when everyone is rich.

Long-term returns are being measured with a rubber ruler.

I'm not sure this debate is as relevant as we thought it was. Now we know about "claw-back." It isn't really your money, so the returns aren't really yours. You just get to manage Trust fund money, and get paid a fee if you outperform the market.

Ignoring inflation in those returns? Hmmmm...

Seems a little off.

In any case, there's an overreliance on capital gains right now..dividends are pretty much microscopic, if they exist at all. (If anybody has any examples of any larger dividend payouts, please contact me via e-mail. I'm really looking to understand the sensibility of this stuff. And I know about MS' generous 3 buck a share one-time payout.)

Once the psychological edge comes off the stock markets, the price values are going to drop, and drap hard. Yes, people and the investment firms are making money. But you have to look at where that money is coming from.

ChasHeath

"Even with the cut in dividend tax rate, the dividend payout ratio hasn't gone up noticably. We've had a big recovery of earnings since the collapse in 2002 and a comparatively small change in dividend payouts. So, companies don't know what to do with funds, but they're still not paying a whole lot more out."

Important and bothersome observation. The S&P dividend yield is 1.59% after Vanguard costs.

One fault in the argument of 5% real return vs. negative returns in the trust fund is that the amount of capital does have influence on returns, the venerable notion of diminishing returns to capital (if there are constant returns to capital, it's a whole new world--).

Suppose, the government can borrow at 3% (real) and is not beyond some limit of indebtedness. Then it can put the proceeds into index funds and get those real 5%. It would make 2% a year, at least over long enough horizons.

The catch is that if you massively bought stock, its yield would fall. So a massive investment into SS acounts could well run the economy into diminishing returns, lowering profits and dividend yields.

IMHO, the whole debate is a straw-man, the veil-of-money error. If worker/retiree ratio goes to 2/1 (1/1 in some countries), the share of GDP consumed by retirees will rise, whatever the method of income distribution is (Direct as today or in the form of dividends--workers will invariably receive less dividends).

Rob Arnott and Peter Bernstein published a paper in 2002 that suggests your past and future returns are overstated. Essentially, they found that US stock returns since 1802 have been LESS THAN the earnings yield. Either your or their numbers must be wrong. See "What Risk Premium Is Normal?," Financial Analysts Journal, March/April 2002, pp. 64-85 (and esp. the middle of page 70).

Not that I believe in the equity premium, but there could be some reasons for higher PEs than in the past that Dr. Delong ignores.

One is that in the early years (Cowles index years 1871 to 1915-20 or so) most of the companies traded were Rail Road companies. And by most I mean about 95%. Hardly the sort of business with lots of exciting developments in R&D by that time.

[Ah. But they were. They were the high-tech companies of the 1870s]

Today the biggest market cap companies are research oriented (MSFT and GE). If companies today will probably experience faster earnings growth than past companies, it is perfectly reasonable to see higher prices in today's companies relative to their present earnings.

Second, in the early twentieth and late nineteenth century we were experiencing very low inflation. Assuming some utility is based on the holding of money balances, increasing inflation will push down the price of money balances reltive to the price of capital.

max U(c) s.t.

f(k,m)=c+d*k+pi*m

U utility, c consumption, k capital, m money balances, d depriciation, and pi= (pt-pt+1)/pt+1

=> U(c)=U(f-d*k-pi*m)

=>dU/dk=U'()*(f1-d)
dU/dm=U'()*(f2-m)

Since (dU/dk)/price of capital=(dU/dm)/price of money,

=>as inflation increases, price of money decreases relative to price of capital.

dU/dm=U'()*(f2-pi)

Sorry.

I just read the Krugman piece and all I have to add is that the privitization cathch 22 is not dependent on a 108% overvaluation of stocks. Even if stocks are fair valued, the slow growth assumed for SS bankruptcy would force corporate profit growth down far enough to eliminate market returns as a privitization rational.

sd wrote, "In an era when the economy is driven by services and technology companies competing in rapidly changing industries, relying on "capital" bases composed largely of things like intellectual and organizational capital, GAAP, as currently constituted, does a very poor job of reflecting economic reality. PharmaCo spends $100M on proteonomics R&D, but since it can't be capitalized under GAAP, has to take a $100M hit to earnings today."

TheJew wrote, "Today the biggest market cap companies are research oriented (MSFT and GE). If companies today will probably experience faster earnings growth than past companies, it is perfectly reasonable to see higher prices in today's companies relative to their present earnings."

Didn't you guys learn anything from the collapse of the 1990s tech bubble?

I have a question posed to me on a discussion of Mr. Krugman's column by a friend of Mine who I'm unable to respond to.

Here's his latest statement:

"What PK's in simplest terms is that the value of the stock market can't grow substantially and continuously faster than the economy, which is true (and self-evident, since if it did its value would grow to exceed that of everything else in the economy). As you note, using the Social Security actuaries this yields abotu a 5% return. Let us remember this fundamentally important fact - a 5% return is much, much higher than the status quo scheme offers.

PK then oddly turns to Dean Baker for help, and for this we get no explanation. He limits growth in future investment by the 2% domestic GDP growth. But why? Domestic GDP growth does not limit the profit growth of companies Americans can invest in. Asia, South America and other reagios will almost surely experience growth rates far and away higher than 2%, and they will need the capital and investment to make it happen. In short, the investment opportunities from billions of people in economies growing at 5-8% annually will be able to lift future profit growth from 2% to 3%. It's an interesting slight of hand for PK and Dean Baker to ignore international economic growth."

http://tinyurl.com/6oytp

The reason Paul Krugman and Dean Baker chose a domestic growth rate of 2%, is that the Social Security administration projected growth rate for the economy is 1.6%. Paul Krugman was being generous. All of the projections that tell us the Social Security trust fund will only last till 2052 are based on the 1.6% economic growth figure that Social Security projects. Paul Krugman is being generous.

Balta, your friend is correct.

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