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December 07, 2004

Dean Baker Gives Us All a Social Security Test

He writes, apropos of Social Security:


MaxSpeak, You Listen!: DEAN RESPONDS TO SAMWICK: I have a test of my own that I have been trying to get economists to take (thus far unsuccessfully), in which I ask proponents of privatization to write down the set of dividend yields and capital gains that will give them the 6.5-7.0 percent real stock returns that they conventionally assume. Such returns were possible in the past because the price to earnings (PE) ratios have historically been much lower and profit growth was much faster. The price to earnings ratio averaged about 14.5 to 1 over the last seventy years, compared to more than 20 to 1 today. This is important, because if 60 percent of profits are paid out as dividends (or used for share buybacks), this gets you a dividend yield of over 4.0 percent with a PE ratio of 14.5 to one. It gets you just 3.0 percent with a PE ratio of 20 to 1, and of course less when the PE ratio is higher.

Let's see... Assume a payout ratio of 60%. Earnings yield of 5% per year... That gives you a dividend yield of 3% per year... That means that the profits of currently existing and traded companies (not aggregate profits!) have to grow at 3.5%-4% per year... That means that the economy as a whole has to grow at 4.5%-5% per year forever... That's much higher than the Social Security actuaries' long-run growth assumption, which heads for productivity growth of about 1% per year and very low population growth by 2050...

In other words, the stock market can attain its 6-7% per year real payoff only if the macroeconomic news in the future is much better than Social Security is projecting, in which case there's no Social Security financing problem at all.

What grade do I get?

Posted by DeLong at December 7, 2004 04:29 PM

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Here's what caught my eye this morning: Alice in Texas explains Liberal Trauma. Brad DeLong on a key problem with Social Security privatization: the economy just isn't likely to grow that fast forever. I see that Captain Ed of CG... [Read More]

Tracked on December 8, 2004 09:00 AM

» Catching my eye: A through Z from The Glittering Eye
Here's what caught my eye this morning: Alice in Texas explains Liberal Trauma. Brad DeLong on a key problem with Social Security privatization: the economy just isn't likely to grow that fast forever. I see that Captain Ed of CG... [Read More]

Tracked on December 8, 2004 09:02 AM

» The End of the Equity Premium? from The Bit Bucket
This strikes me as a serious challenge to supporters of Social Security reform involving personal accounts. The problem, in a nutshell is this: Price to earnings ratios have historically been about 15%. Today, they are about 25%. By definition, that... [Read More]

Tracked on December 8, 2004 10:32 AM

» The End of the Equity Premium? from The Bit Bucket
This strikes me as a serious challenge to supporters of Social Security reform involving personal accounts. The problem, in a nutshell is this: Price to earnings ratios have historically been about 15%. Today, they are about 25%. By definition, that... [Read More]

Tracked on December 8, 2004 10:39 AM

» The End of the Equity Premium? from The Bit Bucket
This strikes me as a serious challenge to supporters of Social Security reform involving personal accounts. The problem, in a nutshell is this: Price to earnings ratios have historically been about 15%. Today, they are over 20%. By definition, that... [Read More]

Tracked on December 8, 2004 10:41 AM

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Tracked on December 12, 2004 04:29 PM

Comments

Brad,
You forgot the Service charges to invest and devest, which will absorb almost all Profits (circular Winners and Losers average) with economic growth of 1%. lgl

Posted by: Lawrance George Lux at December 7, 2004 05:29 PM


Please help me understand what Dean Baker is assuming we might expect from future stock market investments. Why will 6.5% to 7% real returns be so hard to come by? I understand we must count on lower dividends, but why can the rest not be made up by capital gains? I do not understand though I have read the essay several times.

Posted by: lise at December 7, 2004 06:07 PM


To clarify:

Why should economic growth slow in future years when productivity growth has been so promising these past 10 years? Why too should profit growth slow in future? Also, suppose the p/e ratio for the S&P were to be constant at 18 or 20, why should capital gains growth be less than in the past 50 years? Dividends are lower than the historical average, so I can understand this contribution to future stock returns will be lower. But, why should capital gains slow?

Must we expect a substantial difference from the historical norm in the growth of the S&P Index over the coming 5 or 10 or 20 years?

Posted by: lise at December 7, 2004 06:18 PM


Getting in a little over my head on financing, but where did the other 40% of the profits go? We're talking about net profits, right? If it just goes to appreciate the stock, then that value will be eventually realized by the private account stock holders. I think I'm missing something here.

Posted by: Brian S. at December 7, 2004 06:41 PM


Brad and Social Security get "A"s. The privatizers are not doing as well.

Posted by: Dean Baker at December 7, 2004 06:48 PM


Brad - Will you please explain how you derived the data you presented in your example? This is real basic stuff that everyone should know (but unfortunately, we don't).

Posted by: Dennis Victor at December 7, 2004 06:51 PM


Two of the questions that were asked, I can answer.

The other 40% of earnings are retained earnings. They aren't paid out; they are the funds used to keep the business functioning and growing.

In the long run, there is no growth except that of dividends and share buybacks (which are really the same thing, once you do a little math). If you get capital gains in excess of dividend growth, that means that the person you sell the stock to will get less, or he will pass the stock along in the same way. Eventually, the money has to be paid out for the stock to be worth anything.

Okay, yes, there are a few complications in here and it doesn't run quite as cleanly as your Corporate Finance prof told you, but it's close enough to being true for these purposes.

Posted by: J. Michael Neal at December 7, 2004 07:29 PM


This can't be an equilibrium. In Brad's example, the steady state return on physical capital is between 8.75% and 11.25% (growth rate equals retention ratio times marginal RoE), but the owners of the physical capital are only getting 6-7%.

Posted by: dsquared at December 7, 2004 11:48 PM


What J. Michael Neal said.

To make it a little more explicit...all profits are either retained or paid out in dividends. If you have more capital gains, as lise suggests, that means a lower payout ratio, and lower dividend payouts in the short run.

On the other hand, if you pay out more in dividends now, you have less money for reinvesting. The cost? Dividend growth suffers.

You can't have it both ways.

It should be noted that this is one of the mistakes made in _Dow 36,000_. In addition to their questionable analysis of the equity risk premium, the authors made a fundamental conceptual error, not realizing that any profit paid out in dividends is profit unavailable for reinvestment, without risk dividends aren't going to grow.

Finally, there *is* a class of investments whose return grows even without reinvestment. Namely, those involving economic rents. The best example, of course, is land.

Posted by: liberal at December 8, 2004 03:38 AM


lise wrote, "Why should economic growth slow in future years when productivity growth has been so promising these past 10 years? Why too should profit growth slow in future?"

No one---including Dean Baker---is saying that economic growth or productivity growth should slow in future years. Rather, the point is *consistency*. The privatization advocates compare the numbers coming out of the Social Security trustees' reports to the 7% annual average return on equities. But that 7% number is partly premised on historic rates of GDP growth that are much higher than those assumed in the future under the trustees' numbers.

Of course, one could be consistent by positing higher GDP growth rates in the trustees reports.

The point is to not compare apples and oranges.

As for profit growth being low, the rate of profit growth cannot in the long run exceed GDP growth, because profits are income, hence part of GDP. (That claim doesn't take into account the effect of shifting income from labor to capital.)

Posted by: liberal at December 8, 2004 03:44 AM


In other words, the stock market can attain its 6-7% per year real payoff only if the macroeconomic news in the future is much better than Social Security is projecting, in which case there's no Social Security financing problem at all.

This is a devastating criticism. If only it can be made a part of the debate...

Posted by: wetzel at December 8, 2004 06:19 AM


Lise:

Baker isn't assuming anything. What he did was analyse the economic requirements to PRODUCE a 6.5-7.0% return from the market from current levels.

If you assume--as the SSA did when calculating the future "shortfall"--real growth of 1% in the long-term, the stock market model produces something closer to 2-2.5% growth, IF you're lucky. Which does NOT cover the transition costs in going from a system which costs 0.6% of revenues to run to one that will cost anywhere from 2-4% of earnings in an ideal situation--and substantially more when you consider that EMPLOYER costs will, if anything, go UP in the new system.

Posted by: Ken Houghton at December 8, 2004 06:22 AM


And also, if you introduce more purchasers into the market, the prices will be higher.

Posted by: big al at December 8, 2004 06:58 AM


Brad, is there a way to access older items from before the new format? You ran several terrific posts, with lots of expert comments, on Social Security in November.

Posted by: Lee A. Arnold at December 8, 2004 07:01 AM


http://slate.com/id/2099695

"Over the last 20 years, the stock market has averaged a 12 percent annual return. But according to a study by Dalbar Financial, individual mutual fund investors earned only about 4 percent. A survey by Vanguard finds participants in its 401(k) plans earn only about one-half the average—6 percent a year. It is almost impossible to believe, and unpleasant to contemplate, but practically all individual investors are below average. "

Posted by: pat at December 8, 2004 08:57 AM


There is a fundamental error here. Investments are not limited to the United States.

We're are headed for only 2 workers for every retiree when the Boomers retire. Down from 3:1 now. Meaning that to pay promised benefits, payroll taxes will have to be increased by 50%.

Or, as Dean Baker favors, we could allow massive immigration. Or, we could export capital to outside the U.S. and let foreign workers work for us.

Or, we can wait for this prediction from Paul Krugman, Oct 20th, 1996, in the NY Times:

---------quote---------
While the present generation of retirees is doing very nicely, the promises that are being made to those now working cannot be honored.

....to avert the crisis ahead.....slow the growth in benefit levels, gradually raise the retirement age, impose limits on expensive terminal medical care that prolongs life for only weeks or days and -- last but not least -- raise taxes moderately now, rather than massively later.

....Something is bound to give -- but what?

Will retired boomers -- who will have even more political clout than today's smallish population of retired voters -- be willing to accept a sharply reduced standard of living? That is hard to imagine.

Will younger voters be willing to accept huge increases in tax rates to support the boomers in the style they have been promised? That is equally hard to imagine.

Or will the Government try to square the circleby simply printing the money it needs, creating runaway inflation? Surely that is inconceivable. Yet one or more of these unthinkable things will happen, because something must.
--------endquote---------

Posted by: Patrick R. Sullivan at December 8, 2004 09:23 AM


Dquared

I think this can be in equilibrium if the market value of outstanding equity is greater than the value of the physical capital stock.

To go from a return on physical capital of 10% to a return on financial capital of 6.5% (say), you need the ratio of outstanding equity to the physical capital stock to be about 1.5, as (10/1.5) is about 6.5.

Which sounds plausible to me, but, i have no idea if that's close to what prevails today. the larger point is that you can have an equilibrium where the return to physical capital and the return to outstanding stock diverge.

joshb


Posted by: joshb at December 8, 2004 12:50 PM


Patrick,
"... impose limits on expensive terminal medical care..."

is a bit of a give away. Medical care and Social Security are very different animals.

Posted by: theCoach at December 8, 2004 12:51 PM


dsquared

can't the return to outstanding stock diverge from the return to physical capital in equilibrium, if the current market value of equity is greater than the market value of the physical capital stock?

the ratio of equity to physical capital values would have to be about 1.5 to get the divergence from Brad's example, which doesn't sound implausible to me for the US economy, although, i have no idea if that's the actual figure or not.

Posted by: joshb at December 8, 2004 12:55 PM


I thought the relevant population ratio for purposes of the balance of social security wasn't the number of retirees per worker, which is rising, but the number of non-workers per worker, which I believe may in fact be lower now than it was in the sixties.

Posted by: Michael Foley at December 8, 2004 01:25 PM


I thought the relevant population ratio for purposes of the balance of social security wasn't the number of retirees per worker, which is rising, but the number of non-workers per worker, which I believe may in fact be lower now than it was in the sixties.

Posted by: Michael Foley at December 8, 2004 01:26 PM


Patrick is actually making a rather surprisingly good point ... if he lives in Japan. The fact that US is running a current account *deficit* pretty much invalidates his argument i.e. the net foreign investment is in fact negative.

(Okay, I concede the point that with Japan and China buying all the Treasury bills, there's actually a net inflow of investment income -- because Treasury return is much lower but that's not likely to last 75 years into the future.)

Krugman's central point has always been that the ability to pay for SS and Medicare depends entirely on the productivity of the economy. US is a rich country and the federal government has the ability to raise revenue, so we can definitely afford the program. The question is how we do that efficiently.

Like dsquared say, I don't quite get the calculation either. It seems you factor in an assumption that the retention will never be paid out. Can you please post a more detail explanation, Brad?

Posted by: weco at December 8, 2004 02:33 PM


Payout ratio = 60%! Now had Hastert and Glassman let you review their book back in the late 1990's ... then again, their title would have had to been editted as well.

Posted by: pgl at December 8, 2004 03:31 PM


WTF! 4 years ago we had a surplus that was going to eat Wall Street according to Sir Alan. Seems like the fix is easy.

Posted by: dilbert dogbert at December 8, 2004 07:26 PM


Patrick actually has an important point whether he lives in Japan or not, but I do wish he would address the question of how the massive move from a net debtor to net creditor position is going to be achieved.

Not least, foreign countries do not have very many spare financial assets hanging round to be bought up by Americans, and "recycling capital" schemes meant to exploit alleged higher marginal productivity of capital in the Third World have a pretty dismal record of failure.

Posted by: dsquared at December 8, 2004 11:36 PM


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