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April 03, 2005

Asset Returns and Economic Growth

UPDATE: Greg Mankiw has sent along his comments...

There's lots I would dispute. Let me just note one point. Mankiw's last paragraph seems just wrong:

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 asset returns, as far as the debate over Social Security goes, it is largely a non sequitur.

As I see it, there are four important reasons to be against Bush's Social Security plan:

  1. The terms on which it offers private accounts to the non-rich make them not a very good deal.
  2. The plan does nothing to raise national savings in the short and medium run.
  3. Applying price indexation to the bend points produces a Social Security program that is an ever-decreasing share of GDP.
  4. The Bush administration is incompetent--corporate tax bill? farm bill? budget balance? Iraqi reconstruction? handling of our alliances?--and so there's every reason to think bad things would happen in implementation.

If reasons (2), (3), and (4) were not each of them dealbreakers, and if the stock market today were half what it is today, then yes, I would be in favor of a well-designed and well-implemented private-accounts plan (even with the 3% real clawback). With such a high prospective rate of return on equities, the benefits of grasping for some of the equity premium, of prefunding, and of getting a share of Social Security taxes out of the "federal revenues" column would, I think, significantly outweigh the costs of the risk that private-accounts plans impose on non-rich beneficiaries. But with current prospective equity and asset returns, private accounts make no sense with a 3% real clawback.

Max Sawicky reports from the Brookings Institution:

MaxSpeak, You Listen!: GUNFIGHT AT THE BROOKINGS CORRAL: "Dean Baker and Paul Krugman presented their paper, co-authored with Brad DeLong, on 'Asset Returns and Economic Growth,' at the Brookings Institution today. They lay out the problem of what makes a logically consistent scenario of economic growth, in terms of assumptions on interconnected variables, including labor force growth, productivity, immigration, stock prices, returns on equity, etc. N. Gregory Mankiw, late of the President's Council of Economic Advisers, acted as discussant.

The authors zero in on 4.5 percent as the most plausible estimate of future returns to stock ownership. This tracks closely with the 4.6 of Robert Shiller, discussed here previously. When you include this in a diversified portfolio that has bonds and government securities, the average rate of return is much lower than the numbers routinely thrown around by privatization snake oil salesmen.

The paper discusses how plausible economic growth elsewhere does not change the basic scenario, a previously neglected subject.

Mankiw gave me a Groucho Marx moment -- as in, 'who are you going to believe, me or your own two eyes? -- by suggesting that the connection between stock returns and Social Security privatization was spurious. So why, you may ask, are the President and Vice Pres . . . Oh never mind.

Mankiw also accused the authors of Galbraithian lack of faith in 'corporate capitalism,' due to what he construed as their assumptions about corporate dividend policy. This was good timing, since there happens to be an event at Brookings next week about Galbraith and his life's work.

Nobody in the room (about 50 heavy-weight economists) sided with Mankiw's comments. Robert Gordon and Benjamin Friedman made fun of him. Gordon for Mankiw's New Republic article, where Mankiw cited the investment opportunities of the Harvard faculty as a model for working people. Friedman noted that he was implicitly attacking George W. Bush for mixing up the issue of Social Security privatization with that of solvency.

Gordon is much more optimistic about economic growth than the Social Security trustees. This suggests better stock market performance, but it also means the Trust Fund balances persist for much longer than 2041. He said 'the big deal here is immigration.' He went on to point out that a modest assumption about immigration meant a huge difference for labor force size in the long run.

There was a fair degree of consensus, as there is in the literature, that privatization and solvency are two separate matters that don't have much to do with each other. Privatization -- not necessarily in the form proposed by the Bush Administration -- allows the individual to revel in his own risk-taking, enjoying the thrill of success and the agony of failure. It entails the replacement of social insurance with individual saving. You could be for this irrespective of whether the market rate of return is much higher than that under Social Security, or under riskless U.S. government bonds.

Solvency or 'pre-funding' is the grim task of matching the present value of future spending to future receipts, mostly by reducing benefits. An irony of this is that 'solvency' proposals typically take a burden that is otherwise spread over all future generations and concentrate it on . . . why, on you, dear reader. As long as you're under 55. The people who have been told they benefit the most from 'privatization' are precisely the ones who get screwed the worst.

I met Mankiw afterwards. He wasn't too familiar with this site, which was predictable and is probably just as well. I told him I quoted him periodically. He was pleased.

Most of the conference was on some crazy little thing called the current account deficit, which maybe could cause interesting problems in the future.

So Greg didn't say that a 3% real clawback on private accounts is too high? That the clawback rate should be matched to the actual Treasury borrowing rate? Sigh...

Bob Gordon is--as is almost invariably true--smart. Raising immigration by 0.3% of the workforce every year wipes out nearly half of the 75-year Social Security deficit--and that's the decline in immigration that the SSA expects to happen between 2000 and 2030.

Posted by DeLong at April 3, 2005 09:57 PM