Paul Krugman misinterpreted some economic forecasts, and consequently falsely besmirched the reputations of the advocates of Social Security privatization (Is it an odd-numbered day? I am one!). On behalf of both Truth and the Besmirched, I stand ready to provide a bit of assistance with some economic modeling.
First, the False Accusation:
...the numbers the privatizers use just don't add up.
Let me inflict some of those numbers on you. Sorry, but this is important.
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.
...Which brings us to the privatizers' Catch-22.
They can rescue their happy vision for stock returns by claiming that the Social Security actuaries are vastly underestimating future economic growth. But in that case, we don't need to worry about Social Security's future: 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.
Alternatively, privatizers can unhappily admit that future stock returns will be much lower than they have been claiming. But without those high returns, the arithmetic of their schemes collapses.
Is that clear - according to Prof. Krugman, we need high growth to get a high return on capital, and good stock market performance.
This notion certainly has strong intuitive appeal. Most folks who think about the stock market have learned that low growth is bad for profits and sales, and high growth is good; extending that intuition over the next 75 years seems to produce the obvious result described by Prof. Krugman.
However, intuition is not analysis. What went wrong here? For most people, "low growth" mentally translates into "growth below expectations"; high growth becomes "growth above expectations". But there is no reason that a stable, no-growth economy can not have a stable, positive, attractive rate of return, as we illustrate at painful length here. Folks who like to think in terms of financial instruments will remember that a Treasury bond provides no growth at all, but a very stable return.
So what happened with the forecasts used by the Social Security trustees? Well, folks who reflect upon economic forecasts will agree that the return on capital projected by an economic forecast is highly sensitive to the method used to forecast the return on capital. Hmm, does that strike you as painfully obvious? Let me elaborate.
It turns out that growth is not the issue Prof. Krugman think it is. I will grant that the low growth scenario presented by the Social Security Trustees may imply a low return on capital. However, using the modeling method assumed by Dean Baker, economic growth is not a solution.
Economic growth comes from growth in either the size of the labor force, or an increase in the productivity of each worker. Each worker requires new capital, at the same level as current workers. (Beyond that, higher productivity requires capital "deepening", which amounts to more capital per worker - this adjustment makes the Krugman error even more glaring, however).
So, we can get more growth out of economy by bringing in more workers. If, for example, the labor force grows by an additional 1% per year, GDP will also grow by an additional 1% per year. The payroll tax base will rise, and Social Security will be "saved". High growth is good!
But wait - does that new high growth forecast actually imply a higher return on capital? Not as Dean Baker modeled it; new workers require new capital, and the return on capital remained the same as in the original low-growth forecast. This, by the way, is a common-sense result - if a factory with 100 workers manning 100 drill presses sells 100 units and produces a 5% return on capital, then 200 workers manning 200 drill presses should produce 200 units for sale, but the return on capital will still be 5%. Lots of growth, but the return on capital does not change.
Well. Prof, Krugman said "growth" - maybe he meant "productivity growth"?
Maybe he did, but that does not help, as modeled by the Soc Sec trustees and interpreted by Dean Baker. Higher productivity means that there is more output per worker. However, the question instantly arises, who captures the benefit of that increased return? A very common assumption in economics is that workers capture most of that benefit - skilled workers get raises. Higher productivity results in higher growth, but the return on capital does not change; instead, real wages rise.
This outcome can "save" Social Security - the higher wages result in higher payroll tax receipts today (and higher benefits indexed to the wages down the road, but we are moving quickly over a lot of ground here. No, really, this IS quick.) However, even though Social Security is "saved", returns on capital continue to be dismal, as per the original assumptions.
In my factory example above, the 100 workers have a productivity surge and produce 105 units. In the short run, the owner may benefit by pocketing the profit on the additional 5 units. Eventually, however, competitive forces will prompt him to offer the workers raises, or see them leave. That, at least, is the gist of how it has been modeled here.
So, you may be thinking, if the high growth forecasts that "save" Social security don't also "save" the stock market by implying higher returns on capital, why did Prof. Krugman say they did, and is it hopeless for stocks?
As to how Prof. Krugman made an error he would not tolerate from one of his grad students, I have no idea. But the stock market question is easily answered - now that we know that growth, per se, is not the issue, we know where to look - if you want to forecast higher capital market returns, you need to figure out what, in the model, is guiding capital returns. Tweak that, contemplate the implications, and there you are.
Eventually, the analysis will come back to the income share earned by capital. The Social Security trustees assumed it would remain constant; Dean Baker's astute observation [Link, please!] was that, given the current earnings yield and the requirement for new capital, the assumption that the income share to capital was constant led to some fairly gloomy implications for share prices.
Problem solved - we need to raise the return on capital by projecting that capital will earn more. Can we do that in a low growth scenario? Sure.
Suppose the work force grows even more slowly than the low growth scenario because a (daft) Congress cracks down on immigration. Fewer workers, less growth, less payroll taxes, and an earlier problem date for Social Security.
Meanwhile, Benedict Arnold CEOs use the threat of outsourcing to hold down wage increases. Is that implausible? It sounds like the Kerry campaign (feel free to tell me he was implausible). And no, I don't think it would represent a long run equilibrium for the US economy. But during a transition period, the income share of capital could be modeled to rise from, e.g., 8% to 10%. Throw in some foreign profits from the newly outsourced jobs, and equity returns can look pretty good.
Net result - low growth, a quick financial challenge for Social Security (we don't say "bankrupt"), and great stock market returns.
Let's be clear - I am identifying, not advocating. Prof. Krugman insisted, in his column, that growth and capital returns went hand in hand, and implied that privatizers were playing a bit of a shell game with the public. In fact, he was wrong, and there are plausible low-growth scenarios that hammer Social Security but are good for stocks.
I hope that sets the record straight (what are the odds?). There are still plenty of other reasons to support or oppose Social Security privatization (and Republicans are not touting the stock market anyway.
I would like to thank Dean Baker, whose underlying idea was quite insightful. He has been a good sport and provided some useful guidance in an earlier comments thread. I should also find a more useful link, but, incredibly, other duties call.