Despite the title, the post and comments discuss rates of return in the stock markets, so its more an investment related issue than a political one.
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Private Accounts Can Save Social Security (????)
Arnold Kling
Martin Feldstein writes,
With a 3% payroll deduction, someone with $50,000 of real annual earnings during his working years could accumulate enough to fund an annual payout of about $22,000 after age 67, essentially doubling the current Social Security benefit. That assumes a real rate of return of 5.5%, less than the historic average return on a balanced portfolio of stock and bond mutual funds.
Mark Thoma points, but indicates skepticism with a (???). My skepticism runs to 4 question marks. I wrote in 2004 in an essay in favor of privatizing Social Security that what I called the "stock market scenario" is bogus.
The stock market scenario assumes that the stock prices will grow faster than the economy forever. This violates Stein's Law, which says that anything that can't go on forever, stops.
As I explained in the essay, the ratio of stock prices to GDP can be thought of as the product of the price/earnings ratio times the ratio of earnings to GDP. At least one of those ratios has to rise in order for the ratio of stock prices to GDP to rise.
The ratio of earnings to GDP varies depending on the state of the business cycle and on the tax and regulatory environment, which can affect the extent to which people use public corporations as an investment vehicle. (I mention that because some economists think that the public corporation is in decline, due to Sarbanes-Oxley and other assaults.) In any case, the ratio of earnings to GDP certainly has an upper limit.
The main reason that stock prices have risen faster than GDP historically is that the price-earnings ratio was at very low levels a hundred years ago. It has risen gradually since then, although the rise in P/E suffered major interruptions in 1929, 2000, and 2008. In any event, this ratio, too, has a limit.
This means that the growth in stock prices has an asymptote, which is the growth rate of GDP. Unless we approach the technological rapture known as the Singularity (and if we do approach the Singularity, that in itself will eliminate all worries about Social Security, Medicare, and much else), real GDP growth will be closer to 3 percent than to 5.5 percent. In which case, it would be safer to assume stock returns closer to 3 percent than closer to 5.5 percent.
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Justin writes:
Remember there are also dividends. If real stock prices track real GDP growth, a dividend yield in the context of 2-3% would get the total return to 5.5%.
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Yancey Ward writes:
Your future consumption can only be produced in the future; and that product of the future must be shared with the people who are still working at that time; and that rough sharing ratio has been pretty damned consistent over long periods of time (in other words, it is unlikely to change much in the favor of owners of capital).
GDP growth consists of real productivity increases of workers and increases due to growth in population. I think it proper to subtract out any GDP growth due solely to population growth. The investments of today, as a whole, will likely only have real returns equal to productivity increases over time.
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Yancey Ward writes:
Also:
It is true that the indexes change over time, but investors still own the failing/shrinking companies that fall out of them. In other words, the indexes change, but the investors still have to recognize the poor performance of all the companies that are and were a part of it.
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honeyoak writes:
Arnold, i would have to disagree with you on this. in aggregate stock prices relate to the marginal return to capital, not the underlying cash flows as in Modigliani-Miler. ceterious is not paribus,as increases in savings among household can be countervailed by decreases in savings for government and firms. This is why stock prices only correlate with GDP growth for unexpected changes in the economy. That being said, you are correct in pointing out that there is little reason to suppose large returns to savings over the future.
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ed writes:
First of all, it is perfectly possible for assets to generate positive real returns even with no economic/GDP growth at all. This should be obvious.
Second, "returns" are not just "stock prices," they also include dividends.
Third, "stock prices" can grow without any earnings growth at all, due to share repurchases. In the past decades share repurchases have been a bigger source of returns than dividends.
What IS true is that the aggregate P/E ratio can't grow faster than GDP forever. But this statement puts no limit on steady state returns.
(FWIW, I also think 5.5% real returns is a bit too optimistic.)
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Philo writes:
You shouldn't pretend to know what the future growth rate of GDP will be. Prehistorically, and through most of history, it was everywhere much less than 1% per annum; in the nineteenth-century U.S. it was less than 2%. Nowadays 3% seems a reasonable objective for the U.S. (though Tyler Cowen warns of "stagnation"). But China is doing much better than that, and very probably so could we, with better policies here and worldwide. We're doing better at growth than our ancestors did, and maybe our descendants will do even better.
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Chris Koresko writes:
If we think of the GDP as the sum of private-sector and government-sector contributions, then it seems that privatizing Social Security is tantamount to shifting real investment from the public to the private sector. If we assume that the private sector produces higher returns, is it plausible that the resulting increase in GDP could produce the benefits being attributed to the high growth rate of the stock market?
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Charles R. Williams writes:
5.5% returns on stocks in perpetuity can be consistent with a 3% growth rate in output(and equity capital). The reason is that all of this 5.5% return is consumed over the lifetime of individual plan participants. The 5.5% is reinvested only during pre-retirement years. In retirement the whole return and some portion of prior returns are consumed. So the total plan balance across the entire population is a function of demographic factors, labor force participation, wage incomes, and returns on invested capital. The system could be stable over time.
I do think a 5.5% real return on a portfolio of paper assets is unrealistic.
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Lord writes:
The total return is dividends plus dividend growth. Dividend growth will slow with a slowing population but will still grow with productivity and productivity should grow somewhat faster with slowing population due to more investment in human capital but not enough to counter a slowing population. It is really that faster international productivity and population growth that will support higher returns for some time yet but it will fall over time.
The big problem with this is even if you can obtain that high a return, you cannot withdraw at that rate due to volatility. The safe withdrawal rate has been around 4% and a declining return will only reduce that further. As a result, you would need between 2-3 times as high a savings rate to replace that much income or retire later to reduce the length of retirement.
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ed writes:
I believe to a first approximation, if P/E is constant, then:
Return = payout ratio + aggregate earnings growth
Where payout ratio is dividends plus share repurchases.
I agree that earnings growth cannot be permanently higher than GDP growth, and might be lower. But the payout ratio is not negligible. Dividends are around 2%, and share repurchases are similar, so the payout ratio is on the order of 4%. (Note that per share earnings growth will be higher than overall earnings growth if there are net share repurchases.)
I say this is HIGHLY likely to be well above GDP growth. (The other component of returns do to P/E growth or contraction is harder to predict, and will often reverse over time, which is why my bet would not be a total sure thing. It would be better for me if we adjusted the bet somehow to remove this component of returns.)
In any case, I think Arnold's argument is fundamentally flawed, and I'm interested what, if anything, he would be willing to bet on.
ed writes:
To clarify my previous comment, by "payout ratio" meant value of dividends and repurchases divided by stock price. I probably should have called it "payout yield."
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Philo writes:
Even in a steady-state economy--*no* growth--the interest rate will be positive. So there will be a positive return on investment, which compounds over time.
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mark writes:
Further to my earlier comment, I'd like to note that as GDP includes a large chunk of government spending - at cost - GDP is not wholly representative of private sector growth; thus the the growth rates for GDP and the equity market, which functions as a proxy for private sector ownership, could diverge materially.
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Jim Glass writes:
The stock market scenario assumes that the stock prices will grow faster than the economy forever. This violates Stein's Law, which says that anything that can't go on forever, stops.
Stock prices can indeed grow faster than an economy forever.
Total stock valuation, (and income to stock owners that drives that valuation) can't grow faster than the economy forever -- but that's a big difference.
Stock prices can rise even while total stock valuation falls, if enough shares are redeemed and dividends cashed out.
The historical 6% return to stocks is simple interest, not compound. People have always consumed a lot of their dividends, keeping growth of stock valuation in line with growth of the economy.
There's no logical reason why this couldn't continue forever.
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Elvin writes:
Ed is right. I'm surprised at how many people here are forgetting the dividend discount model. Absent P/E effects, the stock return is dividend growth + dividend yield. (And with some simplifying assumptions, it's earnings growth + dividend yield.) Thus, equity returns should be above GDP growth by the amount of the dividend yield.
One way I look at it is that equity returns are above GDP growth and bond returns are below GDP growth. The two together match GDP growth. To grow above nominal growth with stocks, investors have to bear more volatility than economic growth (earnings and the P/E effect are highly volatile). To have lower volatility with bonds, investors have to suffice with a return below nominal growth. I'd guess that Bill Sharpe has some simple theorem demonstrating this. In this sense, Arnold is right: the aggregate gains of the capital markets (stocks and bonds) is probably around the growth rate of the economy.
When we look across broad swaths of history and countries, equity returns have consistently been around 5.0% in real terms. Think of it as 2.5% real growth + 2.5% dividend yield. 5% real returns are not unrealistic, unless you think the great stagnation will get worse.
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Lance Paddock writes:
Absent P/E effects, the stock return is dividend growth + dividend yield. (And with some simplifying assumptions, it's earnings growth + dividend yield.)
Elvin conceptually gets it right, however, Arnold wins on the outcome for another reason, because he is wrong on his assumption. Real Earnings do not equal GDP growth over time. They are significantly less.
Historically real earnings growth has averaged about 1.5% and real dividend growth (more important in reality) about 1.1%. This really makes sense because of two things. First, per capita growth is probably more relevant than aggregate GDP (which has been about 1.8%) then one would expect that public equities would grow slower than the broader economy since they are established and large.
A generous long term view of real returns then is 1.5% plus the dividend yield which adjusting for repurchases can optimistically be put at about 2.3%. That equals 3.8% real.
In reality I would ignore repurchases since over time they are offset by share issuance and the benefit of share repurchases is they supposedly result in higher dividends per share in the future, which has not materialized. Still, no reason not to be optimistic.
I am surprised at how many people in the comments above assert theoretical arguments about what returns, earnings and other factors are, when the information is readily available. The numbers above are the numbers. Opinions about what earnings growth will or should be seems to be placing faith in one's reasoning over experience and evidence from which to reason.
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ed writes:
Lance Paddock,
I suspect you are a bit too pessimistic about some things, but I agree with your conclusion (contra Arnold) that real stock returns will be well above real GDP growth. (3.8% is a lot better than 2.5%.)
Where are you getting the 1.5% earnings growth number? My numbers seem higher (looking at S&P500 earnings since 1960, I get more like 2% or 2.5% depending on how you measure, what period, etc.)
I'll have to think about your dim view of share repurchases. Perhaps my view of them is too rosy.
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Less Antman writes:
On economics, I bow to the wisdom of Kling and Henderson, but as a money manager, I believe I have a better understanding of the present issue.
Ed is right. Total return is not the same as the growth rate, unless consumption is zero, in which case everyone drops dead.
Assume no cycles, no inflation, no new companies, no new shares issued by existing companies, no change in PE ratios, every company sells at book value, and no leverage. Let's say the profitability of every company is 6% of equity each and every year, and that every company pays out half of its earnings, which by definition is consumed by the investors, since there are no new companies or shares in my example.
Result? The growth rate of profits is going to be 3% forever, and the total return on stocks is going to be 6% forever. The growth rate in GDP is the GROWTH RATE of product. It is NOT the TOTAL PRODUCT.
In numbers?
You invest $1,000 and earn 6%, or $60. You spend $30 and reinvest $30. Next year, you have $1,030 invested and earn 6%, or $61.80. Your earnings grew by $1.80/$60.00, or 3%, but your rate of return was 6% in both years.
Stock returns will exceed GDP growth in any society whose people consume any of the production. The growth in GDP is effectively the FLOOR on returns, not the ceiling.
In the past, we could explain the difference in terms of dividends, but in recent history, dividends have been increasingly replaced by stock repurchases, which are still cash distributions to shareholders even though they aren't reflected in the dividend rate. Nonetheless, the point is that GDP growth is not the limiting factor on total return, because it ignores consumption. There isn't a single country in history whose stock returns over time were comparable to the growth rate in GDP
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Philo writes:
Current U.S. GDP growth is constrained by the low rate of savings (partially compensated for by investment in the U.S. from foreign sources). Faster GDP growth could be achieved through higher levels of savings and investment, which would be achieved by ending (privatizing) Social Security. (Another help would be an increased willingness to accept risk.)
Historically investors have been able to get returns higher than the rate of GDP growth, because their saving (and risk-taking) has been partially offset by others' dissaving (and others' declining to accept risk). This would continue to be the case even if Social Security was terminated; there would still be younger people who were temporarily borrowing for consumption (or for investment in their own human capital, which isn't usually counted as "investment"); and there would still be retirees systematically drawing down their savings. Those who are saving and investing domestically (and accepting risk) get a disproportionate share of future GDP.
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A Bet I Will Make
Arnold Kling
...1. national output = national income (note that is true by definition in a closed economy, but in an open economy you can in theory earn income on other countries' output. Let's ignore the open-economy case here and assume a closed economy.)
2. national income = labor income + capital income + rental income + other
3. capital income = income accruing to shareholders of public companies + interest income + income of privately-held companies + other
4. Leaving out pathological examples that make certain types of income negative, it is impossible for something on right-hand side of one these equations to become larger than the left-hand side. For example, it is impossible for income accruing to shareholders to exceed all of capital income.
5. Therefore, income accruing to shareholders of public companies can never exceed national output.
6. If income accruing to shareholders grows faster than output indefinitely, then eventually income accruing to shareholders must exceed national output.
7. Therefore, income accruing to shareholders cannot grow faster than output indefinitely.
I will bet that you can find nothing wrong with that proof.
Many relevant time horizons are shorter than "indefinitely." Shorter time horizons may present investors with the opportunity to earn income that grows more quickly than the economy over the relevant time horizon. You are always welcome to make a bet on that by buying mutual fund shares. I have some myself, although these days my portfolio is lighter on U.S. stocks than usual. For Social Security., though, the time horizon you want to think about is pretty long.
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Joel writes:
Still seems to me that two concepts are being confused here. What counts is the return to investment in equity capital, not the rate at which stock prices grows. If GDP is static, and profits are static, and stock prices are static, it doesn't follow that the return to equity is zero. Companies can still be profitable and paying dividends, and the dividend rate would be the return to the equity investor. Similarly, it doesn't follow that the return to equity investors in a growing economy (when they benefit both from the dividend rate and stock price growth) is limited to the rate of GDP growth.
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Jim Glass writes:
First, stocks can provide a return greater than the growth rate of the economy, and do so forever, for a simple reason: stock returns are simple interest, not compound.
This in fact is the way that stocks have always provided their high returns. Historically while the S&P has provided its 6% real, the capital value of the S&P stocks has grown only slightly faster than GDP. People consume a lot of their dividends. There's no reason why this couldn't continue forever.
Second, note that the SS Trustees say today's and future participants will take a net *loss* on their contributions of $17 trillion.
This is because SS is a paygo program, so total "tax collected" must equal "benefits paid" in the end. And early retirees, up through roughly today, have earned $17 trillion in benefits in excess of the taxes they've paid in -- is it any mystery why SS was so popular!?
But this also means future retirees -- starting with today's workers, age 40s or so and under -- must get back $17 trillion less than they pay in to reach "paygo balance". That is, they must pay taxes to cover their own benefits *and* pay $17 trillion more to prior workers for their benefits -- meaning, by arithmetic, their benefits must be $17 trillion less than the total tax they pay.
Now markets can be risky -- but it takes a government to guarantee today's workers will lose money on their total investment over a full 60 years!
This *negative* forced return from future SS must be considered in when proposing any "solution" to its problem. In fact, "who will eat the $17 trillion loss?" *is* the fundamental problem of SS, which all proposed reforms dance around without mentioning it explicitly.
Third, IMHO, private accounts could have been a big help to SS and the fiscal health of the USA post-2030 if adopted back when first seriously proposed, around the time of the SS Advisory Commission of 1994.
But too late now.
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Jim Glass writes:
In the real USA corporate profits have been pretty steady at around 7% of GDP for the last 70 years. (See the link in my comment above.)
That answers a lot of questions. No growth faster than the economy through compounding returns. The number of shares those profits are divided among determines earnings per share. Changes in the discount rate determine market valuation and p/e ratios.
If the future resembles the past, dividend rate of return exceeding the growth rate of the economy will always be possible -- but market valuations growing faster than the economy indefiniely will not, as profits stay at an even level in the economy. (Again, the difference being between simple interest and compound interest).
Caveat: That, of course, is with the fairly closed-economy investing opportunities of the long-term past. Today the S&P 500 earn a great deal of their profits abroad (about half, IIRC). Most of that comes from other mature economies growing about as fast as the US, so it doesn't make much difference for this purpose.
But if major new int'l "growth funds" traded in the US come to tap in a major way into China/ India/ Asia when growing much faster than the USA, the future could be different than the past.
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A dude writes:
there are many ways to frame the answer, but my favorite is this:
If more is allocated to stocks the aggregate cost of risk taking (risk premium) in the economy goes down, this acts as a subsidy to enterpreneurship, and likely increases GDP growth. How that higher GDP growth is allocated between labor, enterpreneurs and stock owners is another matter.
If SS contributions are diverted to stocks, less financing is available to the government, raising the cost of treasury debt, and reducing governemnt share of the economy, thus increasing GDP growth.
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Steve writes:
Arnold,
Your theory talks in gross terms. The commenter was talking in percentage terms. If:
1. Gross shareholder returns represent only a small fraction of gross national product, and
2. A high portion of gains in gross national product accrue to shareholders, then
The percentage growth in the stock market can exceed the percentage growth in national product. Obviously there is still an asymptote we reach; at some point equity growth slows down to growth in national product in percentage terms, but so long as we are still in a scenario where shareholders only receive a small fraction of the national product then we could have a long time to go before the asymptote is reached.
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