Thursday, February 10, 2005
The Council of Economic Advisors gives an economics lecture to Paul Krugman and Dean Baker. And a new challenge arises for economists who don't want to be left behind!
Sayeth the CEA: an international economist should remember the economy is international; and prices (even of such things as equity investments) are set by supply and demand, not the growth rate of an economy.
THREE QUESTIONS ABOUT SOCIAL SECURITY
This white paper addresses three questions ...
II. Are projections of future stock returns realistic given the outlook for long-term economic growth?
Yes. The Social Security Actuaries assume that stocks will provide an average real return of 6.5% per year over the next 75 years. Some argue that this is unreasonably high if, as the Social Security Trustees predict, economic growth will average only 1.9% per year in the future. This argument is incorrect; the stock return and economic growth assumptions are not inconsistent.
The Actuaries’ financial assumptions are consistent with historical experience and other professional estimates.
...In its most recent analyses, the non-partisan Congressional Budget Office (CBO) makes similar projections. CBO estimates that the long-run real return on government bonds will be 3.3% per year and the real return on stocks will be 6.8% per year...
The Trustees predict that economic growth will slow primarily because of slower population growth. Slower population growth need not imply lower stock returns.
• The Social Security Trustees project that economic growth will slow in the future, primarily because of slower population and labor force growth. Some observers believe that this growth slowdown will reduce future stock returns.
• Although short-run movements in growth can affect stock market returns, there is no necessary connection between stock returns and economic growth in the long run.
Long-run 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... [CEA (.pdf)]
" ....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".
... doesn't seem a whole lot different in substance to me than what was written here all of two days ago...
In light of which we now post right here a new Scrivener.net "No Liberal Economist Left Behind Challenge" for Paul Krugman, Dean Baker, and those who proselytize their case. To wit:
But the simplest answer to the Krugman challenge is just to set the GDP growth rate that determines the rate of growth of US corporate earnings as the world GDP growth rate.
Do that and if world GDP grows at 4% over the next 75 years that's two extra points and there we are -- right back to the stock market's historic 7% return...
After all, economists have long observed that market conditions in different parts of the world tend to equalize when they come into contact.
So investors in Stockholm today have the opportunity to invest their private social security accounts to earn pretty much the same returns as are available to investors with private social security accounts in London -- irrespective of how the trend lines of Swedish and British GDP growth may diverge...
Assume for the next 75 years a 3.5%-or-greater world GDP growth rate that will be sufficient to support 6.5% equity returns in the rest of the world, as per historical experience and the Baker/Krugman "GDP growth determines equity appreciation" principle ... a 1.9% US GDP growth rate ... and the continuation of the trend of steadily increasing globalization of international markets -- financial markets in particular -- with barriers between them falling and declining transaction costs.
Given the above, please state exactly what will be the mechanism that will restrain equity appreciation in US financial markets to only about half the rate of that in the other financial markets of the world (that is, to about 2% in the US versus 3.5% to 4% elsewhere), reducing the total rate of return on US stocks to significantly below that on stocks in other world markets.
Note, this mechanism must be so forceful and convincing as to make it "mathematically impossible" (Krugman's words) for rates of return in open US financial markets to equalize with those in other open global markets -- even as the economy of the rest of the world triples in size relative to that of the US over 75 years.
Specify that mechanism!
Contest winners and prizes awarded will be determined in the sole opinion of the judge(s), no matter how arbitrary that decision may be. All attempts to influence the judging will be welcomed.