Tuesday, February 01, 2005

Social Security Privatization and the Stock Market

Paul Krugman's latest wrong-headed argument against the privatization of Social Security appears in today's New York Times. Krugman says:
Schemes for Social Security privatization, like the one described in the 2004 Economic Report of the President, invariably assume that investing in stocks will yield a high annual rate of return, 6.5 or 7 percent after inflation, for at least the next 75 years. Without that assumption, these schemes can't deliver on their promises. Yet a rate of return that high is mathematically impossible unless the economy grows much faster than anyone is now expecting.

Krugman can make all the economic assumptions he wants. And you know that he'll make assumptions which "prove" his case. But he can't argue with history.

The S&P 500 -- reconstructed back to 1870, with dividends reinvested -- grew at an annualized rate of 6.8 percent, after inflation. To repeat, that's a real rate of return of almost 7 percent. What about all those ups and downs between 1870 and 2004? Well, an exponential fit of the growth curve for 1870-2004 gives an annualized return of precisely 6.5 percent -- just what the professor ordered. If 135 years is a too-long run, how about the 59 years since the end of World War II? The rate of return for 1946 through 2004 was 7.4 percent. An exponential fit of the growth curve for 1946-2004 gives an annualized return of 7.1 percent. *

Krugman wants so badly to denigrate the benefits of privatizing Social Security that he'll stoop to any sort of slippery argument. In this case, he makes the following key assertions (my comments are bracketed in boldface):

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, decade after decade. [In fact, the total return on stocks -- including reinvested dividends -- has been rising faster than the economy for at least 13 decades. And it has been rising at an annualized rate of 6.5 percent.]

The price-earnings ratio - the value of a company's stock, divided by its profits - is widely used to assess whether a stock is overvalued or undervalued. Historically, that ratio averaged about 14. Today it's about 20. Where would it have to go to yield a 6.5 percent rate of return? 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). Here's what we found: by 2050, the price-earnings ratio would have to rise to about 70. By 2060, it would have to be more than 100. [The PE ratio on the S&P 500 (as reconstructed back to 1871) has been drifting generally upward. There have been sharp rises and dips in the PE ratio, because of market bubbles and crashes, but it is clear that the perception of risk has diminished with time and that stocks can command higher PE ratios than they did in the past. A statistical analysis of the relationship between PE and total stock-market returns (including dividends), based on 103 30-year periods ending in 1901 through 2004, produces absolutely no relationship between PE and future returns. In fact, for the 134 years (1870-2004) in which the total real return on the S&P 500 averaged 6.5 percent a year, the year-end PE ratio on the S&P 500 ranged from 5 to 33 -- nowhere near the PE ratio of 70 or 100 demanded by Krugman.]

Krugman is simply determined to preserve a wasteful, socialistic relic of the Great Depression. He gives away his game in the first sentence of his article: "The fight over Social Security is, above all, about what kind of society we want to have." The rest is a rather clumsy attempt at economic sleight-of-hand. Well, as usual, Krugman has fumbled his trick.
* I'll have more to say about the significance of stock-market returns, and their relation to GDP, in Part V of "Practical Libertarianism for Americans." For now, I'll just tantalize you with some of the numbers that I'll document and discuss in that future post.