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February 17, 2005

For the Record... A Little Growth Analysis

When the Bush administration Council of Economic Advisers writes:

Publications: CEA White Papers: "Three Questions About Social Security," February 2005: ...there is nonecessary connection between stock returns and economic growth in the long run. Longrun economic growth is determined by productivity growth and labor force growth here in the United States, while stock market returns are determined by the overall cost of capital in the global economy and by the return investors require to bear the risk that comes with equity ownership. There is no reason to believe that slowing population growth in the United States would significantly lower the cost of capital, as set by increasingly globalized capital markets, or the premium required by stock investors...

The implied conclusion that rates of return and rates of economic growth are unconnected is not in general correct. For example, if international net investment positions are small and bounded (as they have been since World War I), if (as it has been for nearly a century) the share of national income earned by capital is stable, and if (as many believe) national savings rates are not very responsive to changes in returns on capital, then the connection between the return on capital r and the rate of real GDP growth y is:

r = a(y + d)/s

Where s is the (gross) share of savings and investment in the economy, a is the share of national income earned by capital, and d is the rate of depreciation.

An assertion that returns and growth rates are unconnected--that economic growth can slow over the long run from an average of 3.4% per year to an average of 1.9% per year without reducing the interest rate--is an assertion that powerful counterbalacing changes are taking place elsewhere in the economy as the growth rate slows. It is an assertion that (a) the share of income going to capital is going to rise substantially (by about 25%), (b) the share of income saved and invested is going to fall (by about one-fifth), (c) the U.S. balance of payments will swing around and run a permanent international surplus of 6% of GDP or so, or (d) some combination of these effects.

Posted by DeLong at February 17, 2005 05:18 PM