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March 31, 2005

Ed Andrews Writes About Asset Returns and Economic Growth

Ed Andrews of the New York Times writes about "Asset Returns and Economic Growth":

The New York Times > Washington > Social Security, Growth and Stock Returns: In barnstorming the country over Social Security, administration officials predict that American economic growth will slow to an anemic rate of 1.9 percent as baby boomers reach retirement. Yet as they extol the rewards of letting people invest some of their payroll taxes in personal retirement accounts, President Bush and his allies assume that stock returns will be almost as high as ever, about 6.5 percent a year after inflation.

'For the life of me, I can't imagine why anybody would argue against young workers having the ability to invest and build a better retirement for their future,' Treasury Secretary John W. Snow said Wednesday in a speech in Bozeman, Mont.

A growing number of economists, however, including many who favor personal accounts, say Mr. Bush's assumptions are optimistic. Many believe that stock returns will be lower than they have been in the past, closer to 5 percent than 6.5 percent, and that returns on a balanced mix of stocks and bonds will be much lower than that.... The statistical battle is politically important. If investment returns are just one percentage point lower each year than predicted, a person would end up with 35 percent less money than she expected after 30 years of saving. Under Mr. Bush's plan, moreover, people would need to earn at least 3 percent a year after inflation just to make up for automatic cuts in traditional Social Security benefits.

In a paper to be presented on Thursday at the Brookings Institution, three economists who are longtime critics of Mr. Bush argue that stock returns are likely to be about 4.5 percent if economic growth slows as much as the administration predicts. 'We find it arithmetically very difficult to construct scenarios in which asset returns are at their historic average values and real G.D.P. growth is markedly slowed,' wrote the economists, Paul Krugman of Princeton University, whose Op-Ed columns in The New York Times have long been sharply critical of Mr. Bush's plan; J. Bradford DeLong of the University of California, Berkeley; and Dean Baker of the Center for Economic Policy and Research, a liberal research organization in Washington.

To make the numbers work, the economists contended in their paper, domestic profits would have to grow far more rapidly than they have in the past, or American companies would have to become huge exporters of capital to faster-growing countries. At the moment, the United States is a huge net importer of foreign capital.... [M]any Wall Street analysts warn that stock returns are likely to be significantly lower in the future for a separate reason: stock valuations are high relative to expected earnings, and they are likely to remain that way. The S.&P. 500 index is currently valued at about 20 times earnings, which translates to an expected return of about 5 percent a year....

William C. Dudley, chief United States economist at Goldman Sachs, estimates that stock returns are likely to be about 5 percent in the future, because investors are accepting lower 'risk premiums.'... 'My view is that stocks really can't deliver the same returns in the future as in the past, unless we have a major decline in stock prices,' said John Y. Campbell, a professor of economics at Harvard University and an adviser to the Social Security trustees on the issue in 2001.... Two recent computer simulations, one by Robert J. Shiller at Yale University and one by the Congressional Budget Office, suggest that even historical stock returns are no guarantee against losing money....

Stephen Goss, chief actuary for the Social Security program, defended the administration's assumptions. 'Keep in mind that we are trying to make projections over a very long time, 75 years,' Mr. Goss said. 'I would suggest that 5 percent at the moment makes perfect sense. But if you buy at another time, when the price-earnings ratio is 10, you would expect a higher return over time.'...

White House officials may be revising their assumptions. N. Gregory Mankiw, who recently stepped down as chairman of the Council of Economic Advisers, said Mr. Bush's proposed break-even rate of 3 percent on personal accounts may be too high. The yield on inflation-protected Treasury bonds is about 2 percent.

White House officials say they are open to proposals for changing the break-even point, which would raise the plan's cost, but Democratic lawmakers remain fundamentally opposed to Mr. Bush's plans.

'The basic arguments are over the extent to which people ought to be given more freedom over their risk and return choices,' Mr. Mankiw said. 'Returns on the stock market may affect the choice people make, but the question of whether they should be given a choice is broader than the issue of returns.'

Four points:

  1. It's not clear to me that Dudley-Campbell is anything other than Baker-DeLong-Krugman seen from the other side. High price-earnings and price-dividend multiplies coupled with slow GDP and profit growth imply low returns. Only if GDP and profit growth is rapid can current stock market levels be consistent with high returns.
  2. The issue separating Baker-DeLong-Krugman from Goss (and others, like MIT's Peter Diamond) is whether the stock market knows what it is doing. As we see it, there are three possibilities. We see all three of these as live. Goss sees only the third:
    1. The stock market knows what it is doing, and it is expecting low long-term returns (because of a fall in the equity premium and an anticipated fall in the rate of profit.
    2. The stock market knows what it is doing, and it is expecting normal long-term returns because it is anticipating relatively rapid long-term GDP and profits growth.
    3. The stock market doesn't know what it is doing, is currently overvalued, and will decline over the next decade to levels that are consistent with historical return patterns.
  3. A Bush plan that had a 2% real clawback rate (or set the clawback rate equal to the Treasury borrowing rate) would be vastly preferable to the current Bush plan: it would accomplish the important task of providing a vehicle for the poorer half of America's population to easily invest in equities on reasonable terms.
  4. Mankiw's invocation of the language of consumer choice and consumer sovereignty makes me very, very uneasy, for reasons I don't have time to set out here...

Posted by DeLong at March 31, 2005 01:06 PM