In his New York Times editorial today, Paul Krugman picks up on Dean Baker's theme of insisting that using historical rates of return on stocks alongside the lower-than-historical projections of economic growth in the Social Security Trustees Report is inconsistent. The argument, in a nutshell, has the following components:
1) In the long run, the corporate profits that generate stock returns can only grow as fast as the economy as a whole. Otherwise, the corporate sector eventually becomes larger than the whole economy, which is inconsistent. The long-term growth rate is 1.9 percent in the Trustees Report.
2) The rate of return on stocks, assumed to be 6.5 to 7.0 percent after inflation when the Office of the Chief Actuary evaluates reforms, must be partitioned into a dividend yield (including repurchases) and capital gains.
3) Since dividend yields are around 3.0 percent (Krugman's figure), that means that capital gains must be at least 3.5 percent.
4) With capital gains of 3.5 percent and profit growth of 1.9 percent, the Price-Earnings ratio will grow without bound. This is the inconsistency that Dean has been highlighting and that Krugman wrote about today.
This is the same argument that Dean posed to me (admittedly, a second time) while guestblogging over at MaxSpeak a while ago. Since that time, I have been working through Robert Gordon's Brookings Paper on productivity growth and some articles by Peter Diamond about what stock returns to expect for the future. I'm not done doing my homework, but here's an outline of a preliminary response:
The critical assumption in the Baker/Krugman example is that the dividend yield doesn't rise above a number like 3 percent, forcing the capital gains to cover the other 3.5 percent and be reinvested in the corporate sector. What if the payout ratio increased dramatically, so that capital gains accounted for only the same 1.9 percent return that matched the growth rate in profits and the economy as a whole? The inconsistency goes away, as the P/E ratio is stable. So one could rephrase the Baker/Krugman critique as, "Because of the low rate of economic growth, those holding to a 6.5 percent return are assuming an unrealistically high dividend yield."
But is a high payout ratio (e.g., 50% larger than what Krugman is positing) so unrealistic? I don't believe that economists as yet have a solid answer to this question, largely because they don't have robust models of what determines the dividend payout ratio. The most frequent answer that I have gotten when shopping this question around to better macroeconomists than I has been that the partition between capital gains and dividends is indeterminate in models used to study long-term growth. The Office of the Chief Actuary certainly doesn't generate its assumptions from a macroeconomic model that requires them to be consistent.
The most realistic impetus to drive the payout ratio higher is that the size of the elderly cohort will increase fairly dramatically relative to the size of the working-age cohort. Over the 75-year period, the projection is for there to be 80 percent more beneficiaries relative to workers. As more and more of the equity is held by the elderly, there will be a greater demand for firms to pay dividends (or repurchase equity) so that the elderly can consume their accumulated wealth.
According to this theory, the reason the economy doesn't grow faster and P/E ratios don't explode despite the solid return to capital is that firms don't reinvest their earnings. They pay out their earnings to satisfy the consumption demands of the large cohort of elderly. That the payout ratio exceeds historical highs is supported by the projection that the relative size of that elderly cohort also exceeds historical highs. Before I hitch my wagon too firmly to this horse, I'd like to know more about the extent to which elderly have a preference for dividends as opposed to capital gains. I would also like to hear more from macroeconomists about how to make internally consistent forecasts of the return to physical capital, the valuation of financial capital, and the role of demographics in both.
A couple of other issues:
First, as an indictment of a system of personal accounts, the Baker/Krugman argument carries more force if the return on equities stays permanently lower over a long period of time rather than being very low in the near term before resuming its historical rate. (Peter Diamond discusses this difference in the paper linked above.) If we set up personal accounts in 2006, and the market tanked in 2007, restoring the historical P/E ratio and thus making historical returns more feasible with a low payout ratio, then we lose money only on the one year of contributions. I should stress that Peter is not a fan of personal accounts--I am citing his paper only to point out where you can read more about the relationship of the Baker/Krugman argument to the timing of the low returns on the stock market.
Second, as I have noted in other posts, I am not wedded to the low economic growth rate assumed in the Trustees Report, but I also think that the mortality projections have life expectancy growing too slowly. If both of those parameters increased, Social Security's financial imbalance stays about the same but the argument I have laid out here becomes easier to make. The faster rate of economic growth makes it possible to have a lower payout ratio, and the greater share of elderly relative to workers enhances the attractiveness of dividends relative to capital gains.
Around the blogosphere:
Max takes credit (appropriately) for introducing this argument on his blog a while ago.
Brad links to the Krugman article, and then takes Luskin to task (appropriately) for the false assertion that higher productivity growth would not improve Social Security's finances. (It would, but it is not clear that sufficiently higher growth to restore solvency completely is realistic. See this earlier post of mine.)
Angry Bear likes the Krugman article, but then wonders about what is happening to national saving. That's close in spirit to the argument I've made in this post, though I am not asserting that AB would agree with anything I have written here.
Atrios links to the article and wonders what rate of growth would plug the hole in the finances. Again, see this earlier post.