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August 10, 2005

Krugman’s Unhappy Returns.

You will all, no doubt, remember Paul Krugman pointing out, with mathematical certainty, that privatizing Social Security,  investment in stocks rather than the Trust Fund, simply could not work.

The piece is here:

The Social Security projections that say the trust fund will be exhausted by 2042 assume that economic growth will slow as baby boomers leave the work force. 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, decade after decade.

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.

There was, as you might imagine, a great deal of comment on this. Brad DeLong, Brad again, Don Luskin, Prometheus 6, One Good Move, Vox Baby (Andrew Samwick), Tom Maguire, A Tiny Revolution, ....well, I’m sure you can google up or get to more via Technorati.

The one critique that made the most sense to me was from Jim Glass (sorry, can’t find the link). Why is everyone assuming that US stock prices (or profits and dividends) are driven by the US domestic economy?:In an increasingly globalized world, surely (or maybe?) we would expect such things to reflect global growth, not domestic?

Ah, but, people cry. Sure, there is some influence but not enough. Case closed.

Now I know that the UK economy is different from the US, we’re a lot more open to trade (as a percentage of the economy), we’ve a smaller home market and thus large company profits disproportionately come from abroad but....but...here’s an interesting figure from today’s Telegraph:

As every year goes by, the components of the FTSE 100 index become less reliant on the domestic economy and more international.

The exact proportion of their earnings from the rest of the world is hard to measure; Cazenove reckons it is 60pc and rising. The figure is even greater for the top five stocks who together make up a third of the index. BP makes just 10pc of its profits in the UK; Shell about the same; Vodafone 8pc; Glaxo 5pc; and HSBC 18pc. Furthermore, as we saw from Standard Chartered's results on Monday, thanks to various accidents of our imperial history, British companies are particularly well-placed to make the most of opportunities in China and India. As far as the Footsie is concerned, it might as well be the eighteenth century all over again.

So fully 60% of the performance of the UK stock market (at least in its upper reaches) is influenced by profits ( using Krugman’s own logic) and economic growth in other countries.

So as the US continues to become a more international economy this will also happen there. So the basic assertion, that slowing population growth will mean slowing profits growth and thus the Social Security private account arguments don’t add up.....doesn’t add up. For we get the majority of our profits growth from places like India and China, where economic growth is higher.

I’d love to see Baker, DeLong, Krugman address that conundrum but I won’t hold my breath for them to do so.

Update. Brad DeLong does indeed respond, see his paper in the comments. He also added this via email:

To say that something is "mathematically impossible" is always a mistake in economics. It's akin to getting involved in a land war in Asia, playing poker with a man named "Doc," or going up against a Sicilian when death is on the line...

August 10, 2005 in Economics | Permalink


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Hmm. I'd point out that the UK is probably an outlier on any scale of foreign vs domestic profits exactly because the 100 is stuffed with giant financial and resources stocks in a comparatively small country. I would suspect the ratio for the US is much lower, in part because the home market is Consumer no.1

Another point is that it may not be such a good long term bet that repatriated profits from China will make the nut. At the moment, most of the returns from US companies' Chinese operations depend on continuing very rapid export growth to the US. At the moment, they're adding capacity at a rate that requires 30% y/y export growth to be utilised. China is a leveraged play on US consumer demand. If the dollar tanks, the US housing market tanks, the budget deficit gets even further out of kilter, one of China's various economic landmines blows; then you can expect those investment returns to tank by a factor of more than 1.

The question is - can you borrow fast enough to consume fast enough to keep the repatriated profits growing faster than the interest and principal on your growing debts? Like driving faster to get to the petrol station before you run out of petrol.

And finally - it would be a remarkable turn-up for the books if , in total, US management was better at investing in markets it knew less about. And when, due to the clawback, you HAVE to make 3% above inflation before you gain anything...well, it might not be impossible, but I'd say it's pretty damn improbable.

Posted by: Alex | Aug 10, 2005 2:03:53 PM

Britain did this in the late nineteenth century. You have to export huge amounts of capital in order to keep rates of return on your portfolio from falling as economic growth falls.

The U.S. does not appear to be on this trajectory.

Take a look at section 6 of


Posted by: Brad DeLong | Aug 10, 2005 3:22:26 PM

The UK stock market - does that contain all UK stocks. I don't think it does does it?

Although I am not sure. I thought a stock market was just a trading system rather than a bundling of assets owned from UK companies? therefore can foreign owned assets list?

Someone who knows what they are talking about (I obviously don't) needs to clarify this...

Posted by: angry economist | Aug 10, 2005 3:39:49 PM

Nice blog.

Krugman's full of history, except the history of the stock market averaging 11% per year since WWII! (a mere oversight, I'm sure).

Posted by: Darwin Finch | Aug 10, 2005 4:25:52 PM

I think DeLong has addressed this one, so I'd exhale if I were you.

Btw, if the USA is going to get 60% of its corporate earnings from overseas, while the UK, France, Germany and Japan do the same, I suspect that there might not be all that much world left for the people who live there.

(also worth noting that main sources of overseas earnings for UK companies is the EU and the USA. Clearly if we just swap claims on each others' earnings we aren't really solving anything this way).

Posted by: dsquared | Aug 10, 2005 4:45:10 PM

Angry: no, it doesn't. There's no need for a company to be "British-owned" to list in London, but listing does involve being legally domiciled in the UK (in a simple case). "A British company"=a company legally registered in the UK=a company listed on the London stock exchange (if it's a PLC).

Further point: regarding the make-up of the UK stock market, there's a pretty steep jump in terms of foreign/home profit share from the FTSE100 down to the FTSE250. The 100, indeed the old FT30, contains the superglobo banks, oils, miners, and Vodafone. Most of the less skewed businesses kick in further down the market - in the mid- and smallcaps. So it's the figure for the All-Share index you need.

DF: Tell me, then, what good the average does you personally if you happened to start paying-in in a peak year and retired in a bad year? It's an average. The problem isn't the aggregate return to all members over time, it's the return to the individuals. Further, it's unwise to set your measuring sticks to exclude discrepant information. You can't guarantee that a WWII-like event won't happen between joining the scheme and retirement. Not just companies, but stock markets, have been known to disappear. But, hey, maybe those Tsarist railway shares'll pay off one day!

Posted by: Alex | Aug 10, 2005 4:54:17 PM

"You have to export huge amounts of capital in order to keep rates of return on your portfolio from falling as economic growth falls."

Hypothetically: if the money now being collected by the US Social Security Administration and sunk into "investments" (a.k.a. federal deficit spending) in the US economy such as ethanol, the federal highway system, grade school performance testing, (choose your own boondoggle) were to be privately invested, where would it go, instead?

Do we suppose that Vanguard, Fidelity, E-trade, and like brokerages would steer workers into investments like domestic ethanol? Or is it more likely that the money would be invested in Exxon, BP, Glaxco -- that is, giant multi-national "blue chip" stocks?

If it is true that the U.S. is not currently on a (desirable) trajectory to support the domestic population of retirees via the domestic economy, what should be done to shift it onto such a trajectory?

Instead of privatizing Social Security, I mean?

Posted by: POUNCER | Aug 10, 2005 7:13:25 PM

Greg Mankiw suggests in his comment on the paper that Brad Delong cites above, that the internationalization of returns could effectively take place through swaps of equity (e.g., GM buys a factory in China and pays for it, directly or indirectly, with stock). In that case, you don’t have to export capital, just pool together domestic and foreign capital. See http://post.economics.harvard.edu/faculty/mankiw/columns/comment_bakerdelongkrug%20.pdf

Posted by: KNZN | Aug 10, 2005 7:30:23 PM

Also, Brad, if it’s true that US rates of return are likely to slow, won’t there be a huge incentive to export capital once people realize this? And how do you reconcile your low growth projections with the observation that foreigners are today willing to export huge amounts of their capital to the US? (Will this change once they read your paper?)

Posted by: KNZN | Aug 10, 2005 8:03:20 PM

I still don't understand the argument against private accounts supposedly represented by the D/K/DeL paper.

For argument's sake lets stipulate that future equity returns in the US will indeed drop a couple points from the historic norm due to growth-slowing demographics....

1) What matters is not future returns on the stocks of US companies but future returns available to US investors. And I don't see the paper predicting that growth in China, India, Asia and the rest of the fast-growing (we must hope) developing world will slow due to US demographics.

So, over the 40+ year time frame we are discussing, what's to prevent US investors from getting on the phone and buying the Vanguard Greater China and India Diversified Growth Fund?

With China's GDP reasonably projected to reach double or triple that of the US over this time, and India maybe having even better long-term growth prospects, plus the rest of Asia and the world, there would seem to be long-term investment prospects here.

Then, of course:

2) Arnold Kling has pointed out that the same logic that implies a decline in equity returns implies one in bond returns as well -- in which case SS's fiscal position is a lot worse than projected today, and it is that much more important to do something about it now.

3) Even future equity returns a couple points below the historic 7% norm beat the heck out of the future nil-to-negative returns coming-from SS. (In fact, just investing in US Treasury bonds directly via one's own account will beat that.)

Posted by: Jim Glass | Aug 11, 2005 4:50:21 PM

I'm also sort of casually wondering about the rates of return on investment during the period 1950-1980 in Germany, Korea, and Japan -- or U.S. military occupied portions thereof. Were these economies growing faster, slower, or the same as comparably sized, non-occupied, capitalist nations such as Mexico, South Africa, or even Australia?

If, as I suspect, the growth rates in U.S.-occupied nations tends to be higher than rates elsewhere would this be a good time to find an Iraqi Index Fund?

Posted by: POUNCER | Aug 11, 2005 7:31:36 PM