« The Wall Street Journal Comes Through Once Again | Main | Peter Gosselin on Inequality and Risk »

February 28, 2005

And Another Excellent WSJ Article--This Time by Mark Whitehouse

The Wall Street Journal cleans up. Here is Mark Whitehouse:

WSJ.com - Social Security Overhaul Plan Leans on a Bullish Market: In selling the idea of private Social Security accounts to Americans, President Bush has repeatedly made a bullish prediction: The stock market will help younger workers get a 'better deal' than they would from traditional Social Security. A number of prominent economists have two problems with Mr. Bush's pitch. First, they say it's too optimistic about the long-term prospects for stocks. Second, it ignores an irrefutable rule of finance: There is no free lunch. Or, put another way, greater returns bear greater risks. 'You can't just sort of invent free return,' says William Dudley, chief U.S. economist at Goldman Sachs Group Inc. in New York. 'If it was that easy, you wouldn't have a Social Security problem in the first place.'...

The program's actuaries predict that over the period of a typical American's career, or 44 years, stocks would return an average of 6.5%, corporate bonds 3.5% and government bonds 3%, all in 'real' terms -- that is, after inflation.... Problem is, the forecasts raise some serious doubts -- to say nothing of conflicts. For example, there is that assumption of a 6.5% annual return on stocks. By contrast, the actuaries' prediction that the Social Security system will become unable to pay full benefits in 2042 assumes that the economy will grow at a rate of 1.9% a year between now and then -- a tepid pace that would be unlikely to produce stock-market returns of nearly 6.5%. Many economists are critical of the idea that stock returns can be so high relative to gross domestic product growth. 'That stretches the imagination,' says David Rosenberg, chief U.S. economist at Merrill Lynch & Co. in New York.

The long-term return on stocks comes from two main sources: growth in corporate earnings and payouts to shareholders, which include dividends and share buybacks. Earnings tend to grow in line with the economy, which means that 1.9% GDP growth typically would produce 1.9% earnings growth. Add to that dividends, which in recent years have averaged about 1.7% of a stock's price, and buybacks, which have averaged about 1%, and the total real return for stocks comes to about 4.6%. Most economists who predict higher stock returns assume higher GDP growth as well.... [C]orporate earnings can't grow faster than the economy forever. If they did, 'then gradually income from the economy would be completely absorbed by the stock market,' says Ethan Harris, chief U.S. economist for Lehman Brothers in New York.... [A] P/E ratio of more than 20 means that the market expects stocks to yield less than 1/20 of their price, or less than 5%. That is easier to reconcile with the Social Security actuaries' GDP forecast, and comes very close to 4.81% -- the average estimate among 10 economists polled for this article....

Under the most recent Social Security-overhaul plan, people who invest in personal accounts will be forgoing a guaranteed 3% real return... the offset rate the government will use to reduce traditional benefit payments.... [U]nless the government lowers the offset rate or real interest rates increase significantly, personal accounts strike many economists as a poor deal on a risk-adjusted basis. 'Would a rational investor borrow funds at a 3% real rate to invest in order to earn a 1½%-2% real rate?' asked Mr. Dudley of Goldman Sachs in a recent research note. 'We doubt it.'

The most bizarre thing--no, it isn't the most bizarre thing, it is just one of many bizarre things that make me question the good faith or the competence--no, make that the good faith and the competence--of those designing and arguing for the Bush private accounts plan--is the 3% + inflation offset required for those who fund their private accounts. This is likely to generate a substantial increase in elderly poverty when a bunch of people reach 65 and find that their private accounts have not been worth the Social Security benefit reductions they cost.

Posted by DeLong at February 28, 2005 08:30 AM