Wednesday, February 02, 2005

A curious question about Krugman's claimed limit on future stock market returns.

In his column yesterday Paul Krugman yet again proclaims that future stock market returns must be lower than in the past and thus can't possibly be "high enough" for private Social Security accounts to succeed. Although he doesn't say succeed at what. Nor does he say why 5% returns forseen for the future won't work while the 6.5% returns of history would have.

(I have my guesses about what he's talking about -- but let's just say that Krugman may not be the guy to unilaterally define the objectives and measures of success for private accounts, as far as many supporters of private accounts are concerned).

By arguing against he-says-not-what, the Professor sets up something of a straw man to play with, and Tom Maguire has the deal on that.

I'll limit myself to one little thing about Krugman's proclaimed limit on future stock market returns that strikes me as curious -- though I don't actually think it is a particularly big deal in this debate myself. I just don't understand it.

Krugman writes....

The yield on a stock comes from two components: cash that the company pays out in the form of dividends and stock buybacks, and capital gains. Right now, if dividends and buybacks were the whole story, the rate of return on stocks would be only 3 percent.

To get a 6.5 percent rate of return, you need capital gains: if dividends yield 3 percent, stock prices have to rise 3.5 percent per year after inflation. That doesn't sound too unreasonable if you're thinking only a few years ahead...

But ... the actuaries predict that economic growth, which averaged 3.4 percent per year over the last 75 years, will average only 1.9 percent over the next 75 years.

In the long run, profits grow at the same rate as the economy. So to get that 6.5 percent rate of return, stock prices would have to keep rising faster than profits....

OK. What he's saying here in simplest terms is that the value of the stock market can't grow substantially and continuously faster than the economy, which is true (and self-evident, since if it did its value would grow to exceed that of everything else in the economy).

This sometimes comes as a surprise to persons who've heard a lot about high historical stock market returns, but it has been true throughout history. For example the rise in the Dow Jones Industrial Average since 1926 has averaged about 2.5% a year above inflation, less than the growth rate of the economy. And the S&P 500 index since 1950 has risen about 4.3% year on average, compared to average real GDP growth of 3.4%, less than a point of difference.

The rest of the 7%-a-year real average return from the stock market over long experience has come in the form of dividends and other distributions.

Now, over the coming 40 years -- which is the period that counts for the coming fiscal crunch -- the actuaries predict real GDP growth at an average of a tad over 2% (The actuaries say income taxes will have to rise near 100% from today's level in that time to service the Trust Funds and Medicare; and 75 years from now, in 2080, whatever we did before 2045 to deal with that will be ancient history).

This coming decline in annual GDP growth from the higher level of today and the past is expected as a result of the coming decline in the growth rate of the work force.

So... putting together the current 3% dividend rate with 2% future growth in the domestic US economy that allows 2% growth in stock valuations, we get via Krugman's logic 5% as the sustainable yield on US stocks in the future.

As far as that goes, I have no problem.

In fact, a 5% real return -- being so much higher than the 1%-to-negative returns to be provided by Social Security to its young participants, as per its actuaries; and than the 2% real return provided by federal bonds since the end of the gold standard (with less than that expected in the next several years) -- clearly creates many attractive opportunities for, and potential benefits from, private accounts in Social Security. But those will be for another post.

Yet I still have this one question.

Krugman got his name in international economics. But in his analysis here he follows the model of Dean Baker ...

I asked Dean Baker, of the Center for Economic and Policy Research, to help me out with that calculation (there are some technical details I won't get into).
He asked Dean Baker? Why, Krugman Dowded quoted Jeremy Siegel of Wharton as the acknowledged maven of stock market returns and an authority on this very subject of future returns just three columns back. Why not call Jeremy? Oh, well ...

Krugman the international economist follows the model of Dean Baker that limits growth in future investment returns available to Americans by the 2% domestic GDP growth speed limit.


That's my one question. Why does he think that domestic GDP growth limits the profit growth of companies -- domestic and foreign -- that are and will be available for US citizens to invest in?

Note that through most of the 20th Century it was indeed difficult to invest abroad due to the various problems we may remember from history books as well as capital controls that lasted into the 1970s. But in today's world, if investment markets aren't globalized then nothing is.

There are more than 4 billion mostly young people in Asia, South America and Eastern Europe who fully expect to experience growth rates far above 2% -- who will need to do so to obtain the level of welfare we have in our western world, so we must hope they succeed. And they are going to need one heck of a lot of capital and investment from abroad to do so.

US corporations won't be able to invest in these places? US investors won't be able to invest abroad? Investment opportunities among nations of 4 billion people growing at 5%, 6%, 8%, annually won't possibly be able to lift the future profit growth rate available to US investors (a subset of 300 million) from 2% to 3%?

You know, that little increase would make a big difference. Just a 1% increase in return compounded annually for 40 years increases wealth by about 50%.

So I'm curious, why do Dean Baker and the international trade economist Paul Krugman deny the possibility of any gain from international economic growth to US investors in the coming 21st Century?

Krugman back in his Slate days certainly used to argue ardently -- against protectionism -- that productivity-adjusted wage levels quickly equalize among industries in international markets, so that supposedly "cheap" foreign workers aren't really the threat to US workers they are often made out to be.

But today he thinks that in investment markets equalization is less likely to occur? That investment markets are less globalized than labor markets?? So that growth rates of 4%, 6%, 8% across nations with populations of billions represent zero net opportunity to US investors?

(I mean, do people in Ontario have their potential investment returns limited to those of firms with exclusively local dealings that are listed on the Toronto stock exchange? Do retirees in Florida have their investment options limited to businesses operating solely in Florida?)

I'm just curious -- why would the international trade economist write off dealings with the rest of the world for the coming 75 years?

And if he didn't, how much higher than 5% might he say possible future returns could be to US investors? 6%? 6.5?

(Remember, the S&P 500 has appreciated faster than GDP by an average 0.9 points a year for the last 55 years. If that keeps up we are already at 5.9% to start with.)
Which brings us to the privatizers' Catch-22.... if the economy grows fast enough to generate a rate of return that makes privatization work, it will also yield a bonanza of payroll tax revenue that will keep the current system sound for generations to come.
Which economy? The Chinese and Indian economies with 2 billion modernizing people? I can see them providing us with some handsome investment returns in future decades -- but not much in the way of payroll taxes, frankly!

(And by the way, getting enough investment returns to extend the solvency of Social Security is not the test of making "privatization work" -- not the test applied around these parts, at least. )

Mr. Baker has devised a test he calls "no economist left behind": he challenges economists to make a projection of economic growth, dividends and capital gains that will yield a 6.5 percent rate of return over 75 years. Not one economist who supports privatization has been willing to take the test.
Does Mr. Baker think China and India will grow at an average exceeding 2% over the next 75 years? If so, then I don't care about his number games for economists regarding domestic firms.

Just have him tell me whether he expects I'll be able to invest in the Vanguard Greater China and Greater India Diversified Growth Funds sometime in this century.