February 02, 2005,
Paul Krugman and Dean Baker have a challenge for those of us who advocate Social Security reform with personal accounts.
Krugman, of course, is America’s most dangerous liberal pundit but maybe you’ve never heard of Baker. He’s co-director of the Center for Economic and Policy Research, a leftist think-tank funded by George Soros. Krugman and Baker were recently cited as “excellent sources” on Social Security reform by the Communist Party USA.
Here’s the challenge, from Krugman’s New York Times column Tuesday:
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.
Krugman is using Baker’s test to try to suggest that stocks can’t possibly have the kind of returns in the future that they’ve had in the past so Social Security reform with personal accounts that could invest in stocks is bound to fail. And he’s suggesting that Baker’s brilliance has stunned the opponents of reform into silence. Hardly it’s just that none of us would have bothered to pay attention to someone like Baker if Krugman hadn’t elevated him to the pages of America’s so-called “newspaper of record.”
It’s dirty work, but someone has to do it.
Actually, it isn’t especially difficult. But to make the exercise interesting, I’ll limit myself to data Krugman himself offers in his very same Times column. Stand back, everybody here goes.
Krugman states that the return on stocks from dividends and share repurchases is 3 percent. He states that “profits grow at the same rate as the economy,” and notes that “economic growth ... averaged 3.4 percent per year over the last 75 years.” It’s simple arithmetic that if dividends grow at the rate of earnings growth, and earnings grow at the rate of GDP growth, and if the dividend and repurchase yield stays at 3 percent, then stock prices must rise each year by 3.4 percent.
That’s 3 percent per year in yield plus 3.4 percent in capital gains. Sounds like a 6.4 percent return, to me. Just a hair shy of the 6.5 percent Krugman and Baker asked for, but I am still going to declare victory.
Even without the arithmetic, there’s nothing so unusual about thinking that stocks could return something like 6.5 percent, after inflation, over the next 75 years. After all, they’ve returned exactly that over the last 75 years, according to Ibbotson Associates. Stocks are somewhat more highly valued today than they have been on average in the past, but that may well be nothing more sinister than a reflection of the risk-reduction opportunities in today’s globalized economy. Besides, today’s valuations are fully reflected in the 3 percent dividend and repurchase yield that Krugman himself posited.
What does the guru of long-term stock investing celebrated Wharton professor Jeremy Siegel have to say about it? According to a Krugman column two weeks ago, “even Jeremy Siegel, whose ‘Stocks for the Long Run’ is often cited by those who favor stocks over bonds, has conceded that ‘returns on stocks over bonds won’t be as large as in the past.’” The point being that Americans would be better off leaving their Social Security taxes invested in the bonds held by the system’s trust funds, rather than investing in stocks through personal accounts.
But Krugman Truth Squad member Jim Glass, on the Scrivener.net blog, caught Krugman “Dowdifying” that quotation. What Siegel really said, after the sentence Krugman deceptively selected was, “I see a 5%-to-6% return on stocks, adjusted for inflation. I’m pessimistic about real bond returns.”
Okay, 5 to 6 percent isn’t quite 6.5 percent. But it’s close. And it’s a heck of a lot better than the rates of return offered by today’s Social Security system. According to the Congressional Budget Office, Social Security offers very poor returns for the median quintile of household earners the present value of their payroll taxes is greater than the present value of their future benefits.
But Krugman does make one good point in Tuesday’s column. He states that stock returns in the neighborhood of 6.5 percent will not be possible over the coming 75 years if economic growth is as low as the 1.9 percent rate used by the actuaries of the Social Security Administration in their solvency estimates. He says that for that to occur, “you have to believe that half a century from now, the average stock will be priced like technology stocks at the height of the Internet bubble and that stock prices will nonetheless keep on rising.”
How did Krugman figure that out? The Princeton economics professor who some people think could someday win the Nobel Prize had to ask Dean Baker to “help me out with that calculation (there are some technical details I won’t get into).” Indeed, Krugman probably needed the help he never has had a very firm grasp of stock market valuation. During that “height of the Internet bubble,” Krugman wrote in his Times column that “I'm not sure that the current value of the Nasdaq is justified, but I’m not sure that it isn’t.”
Hmmm. That wasn’t exactly the unambiguous call to sell techstocks that Jeremy Siegel issued at the height of the bubble, when he wrote a piece titled “Big-Cap Tech Stocks Are a Sucker Bet.” No, as new ex officio Krugman Truth Squad member James Neel put it in an e-mail, “Krugman was for the bubble valuation of Nasdaq before he was against it.”
Today, once again, Krugman wants it both ways. He’s sure that stocks will perform poorly in the future, but he says, “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.” But that’s simply not true.
Kent Smetters, the Wharton professor who has pioneered the analysis of Social Security’s solvency beyond the deceptively arbitrary 75-year timeframe most often cited, told me that faster economic growth amounts to “very little over the long term.” Krugman’s analysis which focuses on the higher taxes collected in the near term ignores the reality that correspondingly “higher benefits come outside the 75-year window.” So you collect more now, but you just pay it out later. That’s largely because a 1977 law, passed by a Democratic Congress and signed by Democratic President Jimmy Carter, indexed Social Security benefits to economy-wide wage growth.
I’d conclude by turning Krugman’s challenge back on him: “Ladies and gentlemen, would you care to explain your position?” But I can’t I’ve been writing the Krugman Truth Squad column long enough to know that he’s no gentleman.
Donald Luskin is chief investment officer of Trend Macrolytics LLC, an independent economics and investment-research firm. He welcomes your visit to his blog and your comments at email@example.com.