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December 26, 2006

Dean Baker on Social Security

Dean Baker has never been all that happy with the idea of the privatization of Social Security, whether in whole or in part.

The country's private pension system is broken, so there is nothing wrong with creating new systems of private accounts in addition to Social Security. However, there are grounds for suspicion about the motives of people who propose such accounts using public funds, esepcially when they make up numbers.

I'm unconvinced that anyone is suggesting using public funds: rather that private funds be used to pay into alternatives before they become public funds sucked into the Social Security system. However, that's not my real point here:

During the Social Security debate last year I challenged all the supporters of President Bush's plan to produce a set of projections for capital gains and dividend yields that would equal the 6.5 percent to 7.0 percent return for stocks assumed in their calculations. (This was the famous "no economist left behind test.") No one could produce the 3rd grade arithmetic that could reconcile these numbers. (Steve Goss, the chief actuary for SS said that he could do it, if stock prices first fell by 16.5 percent -- an assumption that he neglected to include in his projections.)

Now I didn't (and do and would not) claim that I can provide projections which show such growth.

I can however recall what the basic argument was in the Krugman, Delong, Baker paper about why such numbers were impossible. And, if memory serves correctly, that argument was wrong (I'm delighted to be corrected if my memory is more fallible than usual).

Essentially, the structure was this. US Profits (and thus dividends) cannot grow faster than the growth of US GDP. Well, they can't in the long term, without profits becoming an ever greater portion of that GDP, something which presumably, when they were 80% of GDP or so, would lead to a bloody revolution.

Which, in an age of ever increasing globalization is really a rather surprising thing to insist upon. Why should not profits globally grow at the rate of global GDP growth ? Why should investment by US wannabe retirees be solely invested in domestic US stocks? Why wouldn't they buy some overseas stocks?

Further, if they invested in what we think of as US stocks, why should the profits of those companies be limited to US growth rates? GM really only makes money in China, as an example.

I seem to remember something from a few months ago, that more than 50% of FTSE 100 profits now come from outside the UK: so at least 50% of the profits growth on the main UK index is not in fact limited by domestic GDP growth, rather by global GDP growth (or regional if you prefer).

So why can't or couldn't the same thing happen in the US?

As I say, I don't insist this would give the numbers which would make the Bush numbers add up, but I am certain that the limitation placed upon profits growth by that paper is wrong.

December 26, 2006 in Economics | Permalink

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Comments

I think it's because the debate is about investing in American companies. And even if those companies invest abroad, surely that would still count as profits growing as a % of GDP?

In any case practically there are few restrictions on Americans sending their savings overseas, and yet there's not much of it going on.

Posted by: Matthew | Dec 26, 2006 9:42:51 PM

Indeed if the rate of return on investments outside the US is so much higher than that in the US, there shoud be a huge and ongoing net outflow of capital (incentives matter!).

Posted by: Matthew | Dec 26, 2006 9:47:07 PM

Since when has our government concerned itself with common sense?

Posted by: China Law Blog | Dec 26, 2006 11:31:24 PM

Indeed if the rate of return on investments outside the US is so much higher than that in the US, there shoud be a huge and ongoing net outflow of capital (incentives matter!).

Rates of return are much better overseas than in the US, as the US is not an emerging market where rates of return are highest. My savings plan is doing well thanks to my investing in funds such as JF India or Barings Eastern Europe, which are giving me annual returns in the region of 50% and 40% respectively (as part of a 25 year plan). The problem is that such high reates of returns come with an increased risk; if you lower the risk, the returns decrease. Could be that the US investors aren't interested only in returns, they are taking risk into consideration too.

Posted by: Tim Newman | Dec 27, 2006 1:23:24 AM

"Well, they can't in the long term, without profits becoming an ever greater portion of that GDP, something which presumably, when they were 80% of GDP or so, would lead to a bloody revolution."

An interesing comment worth revisiting in five years or so.

Posted by: Martin | Dec 27, 2006 6:43:13 AM

[ as the US is not an emerging market where rates of return are highest. ]

there is surprisingly little evidence of this; most "high risk, high return" markets have returns substantially lower than the USA.

[My savings plan is doing well thanks to my investing in funds such as JF India or Barings Eastern Europe, which are giving me annual returns in the region of 50% and 40% respectively (as part of a 25 year plan)]

If your pension pot is in the region £100k and you are planning on earning a 50% return on it over 25 years, then I calculate that you will own the entire world somewhere around 2027. I hope that you will remember your old mates from the Tim Worstall blog.

Posted by: dsquared | Dec 27, 2006 9:20:55 AM

It's possible that the reason capital is not flowing from the US to overseas markets is because US investors are very risk adverse, and so are induced even by higher returns. But if that is the case (and as Dsquared says, it isn't necessarily) it just restates my point - US investors are not investing overseas (net) despite the higher returns, so to model it as a likely scenario for pension money, of all types of investment, is not sensible (and no-one is suggesting allowing these accounts to invest overseas, I think).

I'm also not sure whether you can talk about investing in Eastern Europe, or other places with high returns, without getting into a with-hindsight stock picking argument. And then you might as well say, "But hey, the personal accounts could have invested in Microsoft in 1990". The only thing that avoids that is to use something like the MSCI-US world index, ie all foreign countries and stocks (at least practical) and this includes places like Japan and some European countries where returns have been less good, and of course markets that have collapsed. Simply in terms of GDP growth, world GDP growth has outpaced US GDP growth, but not by a huge amount, and it has a lot of extra risk to compensate for.

Posted by: Matthew | Dec 27, 2006 10:12:08 AM

In fact whether GDP growth across the quoted sector in the world (ie huge parts of Chinese growth are not investable in) has outpaced US growth is not clear at all.

Posted by: Matthew | Dec 27, 2006 10:13:21 AM

there is surprisingly little evidence of this; most "high risk, high return" markets have returns substantially lower than the USA.

What utter nonsense. Had you a Friends Provident savings plan in place you'd have been better off investing in emerging and overseas markets over the past 12 months than investing in a purely US-based fund as this .pdf shows. Whether this would be the case for the entire period of 25 years is unlikely, but there is no evidence whatsoever to suggest that keeping your cash purely in a US-based fund over 25 years would earn you more than sticking some of it in emerging and overseas markets for a while.

If your pension pot is in the region £100k and you are planning on earning a 50% return on it over 25 years, then I calculate that you will own the entire world somewhere around 2027.

I do hope that you don't give anyone financial advice for a living. Pension funds rarely start out with a £100k lump sum, they usually start with a modest £500 and via monthly contributions and fund value growth accumulates over 25 years to, say £500k. A pension fund worth £100k would be roughly 15-20 years in, with only another 5-10 to run. I very much doubt there are many pensions out there which have a valuation of £100k and another 25 years to run!

Secondly, I didn't say I was getting a return of 50% on me pension, I said I was getting a 50% return on the portion of my pension invested in JF India. This is a significantly greater return than I'd get in a US-based fund, but as I said the risks are higher, hence only 15% of my pension is in that particular fund. Furthermore, if you had a £100k valuation you would not be looking for a 50% return as the risk would be too high and you have a substantial sum to protect, so something like 8% per annum would probably be better. But I am just entering the 3rd year of my pension hence don't have a large valuation to protect and have adopted an aggressive fund selection to get the ball rolling. Once the valuation increase I will scale back the risk and lose some returns as a consequence.

Posted by: Tim Newman | Dec 28, 2006 2:07:20 AM

I'm also not sure whether you can talk about investing in Eastern Europe, or other places with high returns, without getting into a with-hindsight stock picking argument.

Erm, no. It is quite possible not only talk about it, but actually do it as well. I invested 30% of my pension in Eastern Europe a year ago and it has done very nicely, thank you. I selected the fund based on the performance over the past 12 months and as of yet it has not let me down. Of course it might all come crashing down but given that I watch my fund prices daily like a hawk I hope I will get some warning and switch my funds accordingly.

Posted by: Tim Newman | Dec 28, 2006 2:10:40 AM

Er, yes, but your experience proves almost nothing. I've received annual returns of about 25% over the last three years from investing in British brewing stocks, but they are not the solution to US pension problems.

You have to make the case that external stocks always (over a certain time period) outperform US stocks, or that a certain country/sector will. Obviously there will be times when countries/sectors do.

This is why I said you need to look at the MSCI World Index, or at least the emerging-market sub-sector, and see how it performs (and its relative risk profile). And given Americans don't put a great deal of their money into such investments (even though the restrictions on their savings are far less than they would be on a personal pension pot, I'd suggest) it seems they are convinced.

Posted by: Matthew | Dec 28, 2006 9:32:09 AM

Er, yes, but your experience proves almost nothing.

It proves that:

I'm also not sure whether you can talk about investing in Eastern Europe, or other places with high returns, without getting into a with-hindsight stock picking argument.

is bullshit.

You have to make the case that external stocks always (over a certain time period) outperform US stocks, or that a certain country/sector will.

No, I don't. I simply responded to your nonsensensical suggestion that rates of return in the US are higher than elsewhere, hence US citizens don't want to invest outside the US. Or something. A cursory glance at the stock performance over the past 12 months will tell you that some emerging markets have outperformed the US, and have given you an example of the JF India fund to demonstrate this. This is unsurprising as emerging market funds are set up for the specific purpose of giving greater returns, albeit with a higher risk.

Therefore, I think the onus is on you to explain why you believe US-based funds outperform all others and give some examples.

Posted by: Tim Newman | Dec 28, 2006 9:52:08 AM

No, it's not bullshit. "A cursory glance at the stock performance over the past 12 months will tell you that some emerging markets have outperformed the US" - is a with hindsight statement.

Furthermore, you can't go from your example, to one that is relevant to the US pension industry. If I said 'the solution to the US pensions crisis is clearly to invest in UK brewing stocks', I could easily show they outperform broad-based US indicies in certain (recent) years. But it wouldn't be particularly illuminating.

To credibly say that US pension returns can be improved by overseas investments requires either a) that overseas investments on aggregate return more than US investments, or b) the sectors or sub-sectors that do are on average identifiable in advance (and indeed return more than sectors or sub-sectors in the US) and finally, c) that they do a or b with an acceptable amount of risk.

As i said the fact that US investors can invest abroad, and most choose not to, is interesting.

Posted by: Matthew | Dec 28, 2006 10:09:26 AM

No, it's not bullshit. "A cursory glance at the stock performance over the past 12 months will tell you that some emerging markets have outperformed the US" - is a with hindsight statement.

Yes, it is - and not relevant to the passage which I was saying is bullshit. Initially, you said:

I'm also not sure whether you can talk about investing in Eastern Europe, or other places with high returns, without getting into a with-hindsight stock picking argument.

and I then countered with:

It is quite possible not only talk about it, but actually do it as well. I invested 30% of my pension in Eastern Europe a year ago and it has done very nicely, thank you. I selected the fund based on the performance over the past 12 months and as of yet it has not let me down.

Which you said proves nothing. And that is wrong. It proves that having watched Eastern European funds perform well over a previous 12 month period, it can be assumed with a certain degree of confidence that they will perform well for the next 12 months. Selecting funds for the future based on past performance is not a "with hindsight" statement.

To credibly say that US pension returns can be improved by overseas investments requires either a) that overseas investments on aggregate return more than US investments, or b) the sectors or sub-sectors that do are on average identifiable in advance (and indeed return more than sectors or sub-sectors in the US) and finally, c) that they do a or b with an acceptable amount of risk.

I can credibly say that the US pensions can be improved by US citizens not limiting their investments to US-funds, and consider investing a portion of their pension in emerging markets such as India or Eastern Europe. Indeed, it is an inherently sensible idea to spread your investments geographically as well as across differing funds.

If, as you suggest without bothering to provide any evidence, that US funds outperform overseas funds to the extent that no US pensioner should consider investing in them, then it leaves me wondering why anybody invests in non-US funds at all. Shouldn't our financial advisers all be steering us away from non-US funds?


Posted by: Tim Newman | Dec 28, 2006 11:03:04 AM

Tim, do you remember a few posts ago saying "Whether this would be the case for the entire period of 25 years is unlikely"? Did you realise at the time that this was a pretty important concession you were making?

Emerging markets have high returns in good years and very large negative returns in bad years. So the question is, are the good years good enough to compensate for the bad years?

And the answer is "on the basis of the historical evidence, no they aren't". Emerging markets in general, over time periods long enough for the political cycle to be a factor, perform worse than the USA.

Posted by: dsquared | Dec 28, 2006 11:21:06 AM

Did you realise at the time that this was a pretty important concession you were making?

No, it isn't, because nobody is obliged to keep their money in the same fund for 25 years. There is nothing to stop somebody investing their money in the US when the emerging markets are not doing too well and then switching into them once they have picked up. The fact that over 25 years the emerging markets do not outperform the US based funds does not prevent somebody from investing for a year or two in an emerging market which during that period is outperforming the US based funds.

Only a complete twerp would choose his fund selection on the basis of the performance of those funds over 25 years. The idea is you choose funds which are likely to perform over a certain short period and then switch to something else later as circumstances change. Therefore, the performance of a particular fund - including an emerging market fund - over a 25 year period is utterly irrelevant.

Posted by: Tim Newman | Dec 28, 2006 12:01:44 PM

What you're basically arguing is that if US investors are great stock/sector/market pickers (though I'd go easy on your past performance is a good guide to future returns strategy), they will achieve higher returns than average. This is uncontroversial but largely irrelevant, as on average a typical investor is not going to be better than average.

The issue is whether investing in foreign stocks will lead on average to higher returns for all investors. I've said (contrary to what you say above) that it might, but the evidence is not particularly strong, and furthermore given what we know about the behaviour of US investors in investing overseas they clearly don't on the whole think it is a good investment (whether because of the return or the risk), and thus it doesn't really make much difference to Baker's calculations.

Posted by: Matthew | Dec 28, 2006 1:11:22 PM

[ There is nothing to stop somebody investing their money in the US when the emerging markets are not doing too well and then switching into them once they have picked up]

Tim, the trouble is that when emerging markets start "not doing too well", they have this tendency to suddenly halve overnight, and a 50% loss requires a 100% gain to get you back where you started. Also, you don't tend to get much warning of these sudden crashes.

One thing that has to be pointed out here as well is that any massive net investment by the USA overseas would have to have a current account counterpart. I've never heard anyone explain how the USA is going to go from having a very big current account deficit to an equally huge surplus, without any problems.

Posted by: dsquared | Dec 28, 2006 1:47:07 PM

Tim, the trouble is that when emerging markets start "not doing too well", they have this tendency to suddenly halve overnight.

Not necessarily. There are plenty of funds which spread the investment over several emerging markets (the most popular one of late being the Brazil-Russia-India-China [BRIC] fund. This protects against the entire fund crashing at once, although returns are not as good as investing in a single-country fund. In addition, the number of emerging market funds which halve overnight and never recover are these days relatively few, and for those that do - such as the Saudi and UAE markets earlier this year - they could be seen a mile off.

Posted by: Tim Newman | Dec 28, 2006 2:16:33 PM

What you're basically arguing is that if US investors are great stock/sector/market pickers (though I'd go easy on your past performance is a good guide to future returns strategy), they will achieve higher returns than average.

No. I am saying that if US investors put a little more thought into their fund selection they'd see that investing a portion in overseas funds would yield better results than keeping only US based funds. Of course, this would require a bit more effort on the part of the investor (no, they don't need to be "great stock pickers", they just need to put some basic research in), but this seems a better idea than putting it in low risk, low maintenance US based funds and leaving it sit for 25 years then being disappointed at the end result.

This is uncontroversial but largely irrelevant, as on average a typical investor is not going to be better than average.

On average a typical investor is not going to be better than average? Having read this thread a couple of times, I'm beginning to see a possible reason for pensions being in the state they are!

Posted by: Tim Newman | Dec 28, 2006 2:26:29 PM

[There are plenty of funds which spread the investment over several emerging markets (the most popular one of late being the Brazil-Russia-India-China [BRIC] fund.]

Yes, I remember this being a characteristic of those funds in 1998 which had also diversified their investments between Indonesia, Russia and Argentina. It didn't work. Emerging markets always look great, except when they don't. If you wanna have a punt on them, or to encourage others to do so, then go for it but don't pretend that this is a solution to the pension problem.

Posted by: dsquared | Dec 28, 2006 4:31:53 PM

This isn't going anywhere, but I'd just add that when you say:

No. I am saying that if US investors put a little more thought into their fund selection

This seems to be a case for actively managing portfolios that would be hard to justify in terms of return compared with expense.

Posted by: Matthew | Dec 28, 2006 5:35:58 PM

Emerging markets always look great, except when they don't. If you wanna have a punt on them, or to encourage others to do so, then go for it but don't pretend that this is a solution to the pension problem.

I'm doing no such thing, as a solution to the pension problem will be extremely complex and will take more than a bit of trial an error. But investing outside of the USA - and not just in emerging markets - is a tool which could and should be used as part of the solution.

This is especially pertinent now as opposed to a decade ago when the world economy was utterly dependent on the US economy. It is believed that the world economy may now be robust enough to withstand a downturn in the US economy. This being the case, it would seem inherently sensible for US citizens to invest some of their pension in funds which could withstand a downturn in the US economy.

Posted by: Tim Newman | Dec 29, 2006 1:25:26 AM

This seems to be a case for actively managing portfolios that would be hard to justify in terms of return compared with expense.

Actively managing portfolios costs nothing thanks to the internet. You can access all fund prices at the click of a button along with charts of past performances, and switch your fund selections in seconds. There is no expense involved whatsoever, except for a little time. The returns, however, are significant.

Posted by: Tim Newman | Dec 29, 2006 1:29:40 AM

But just to repeat you can't talk about individual markets or sectors, as that doesn't fit in with Baker's analysis, which correctly looks at the entire US equity market (at least implicitly). Otherwise, as I noted, you could point out that an investor who chose his sectors carefully, tech/chemical/banks, could easily outperform the market.

Posted by: Matthew | Dec 29, 2006 10:13:55 AM