[LATE UPDATE: I claim the Dean Baker "No Economist's Left behind" Cup here.]
How one could make money from writing a blog has vexed greater minds than mine. And how one might make money by *reading* them has been truly puzzling.
I have a longish, confusing-ish post making a point about Social Security, economic growth, and returns on capital that, when understood, is so obvious folks will wonder what the discussion was about.
However, my point stands in direct contradiction of a column written by Paul Krugman, and (so far) has not found support anywhere in the blogosphere.
So, my proposition - I will pick out a couple of key phrases that summarize the Krugman argument, and put my money where my mouth is. If a consensus emerges that I am correct, you pay; if, OTOH, I am wrong, I pay. The technical term for this is "wager". (Let's just add, VOID where PROHIBITED! And for those who prefer, settlement can occur in the form of a donation to a charity of the winner's choice, subject only to a "nothing embarrassing, no hideous mailing list" type of restriction.)
Now, frankly, I ought to be the underdog here - we are talking about macroeconomic forecasts, and Paul Krugman is who he is (I am who I am, too, but what is that?)
And, as regular readers know, there is a certain "stopped clock" quality to my criticism of Paul Krugman. Oh, I may think I score the odd success, but frankly, if Krugman said "Good morning", I would probably put up a post saying it's nighttime in Tokyo, and wondering how a guy with a reputation as an international economist could possibly overlook that trivial and obvious fact.
Well. The wagers. Despite my heavy underdog status, I will put these up at even money. $100 on this one:
...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.
Emphasis added. In my post I demonstrate that higher growth at a low return on capital does not increase the return on capital (no, seriously - Krugman really is on the other side of that proposition, although he probably does not realize it).
SO, the bet - I win your money if:
(1) some credible economists emerge to endorse the notion that the return on capital question is separate from the economic growth question (i.e, taking the low growth/low return scenario and increasing growth does not automatically turn it into a high return on capital scenario, but rather, can simply turn it into a high growth/low return on capital scenario); that the projected return on capital depends a lot on how you forecast returns on capital (I'm really on a limb with that one); and, here we go, that there are mathematically possible and economically plausible scenarios where we have low labor force growth and low (1.7%) productivity growth, but high stock market returns. I am not even holding out for more foreign income on this point, although I suppose I could.
Just to handicap this a bit, I will even tell you the winning argument: the return on capital is determined by the income flowing to capital (the income share of capital) and the level of capital employed. In the high growth scenarios, we need to model levels of investment (replacement plus new investment), a capital/labor ratio (those new workers need capital to be productive), and an income share to capital.
What folks will realize, upon reflection, is that the return on capital will only go up if the relative capital deployed falls, or the income share of capital rises. The notion that either of these ratios must be directly dependent on labor force growth or productivity growth will not be sustained - in fact, their behavior is a result of modeling choices. In short, higher growth does not automatically increase the return on capital.
Having settled that, folks will ask what might increase the return on capital. Increasing the income share is an obvious way.
So, in a low growth environment, suppose that productivity growth is 1.7% per year, but for two years, real wages are *flat*, so that the increased income from the increased productivity goes to capital. The income share of capital will rise from roughly 8 to 11%, which will take the return on capital from 5% to 6.5%. Bingo.
So, a fine bet, yes? Takers are invited to enlist in the comments section. Should be an easy $100. Krugman versus The Minuteman! Help me out, help yourself out, win my money!
You want more?
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.
That may or may not be true as an historical fact, and who cares? Shall we wager on this:
(2) profit growth is not the same as return on capital; a firm, or an economy, can have high profit growth with a low return on capital, or low profit growth with a high return on capital. (HINT: Don't forget dividends!)
Go ahead - if we find a consensus that my statement is false, you win. Make it another $100. Now, does my statement directly contradict Krugman's? It certainly runs counter to the spirit of his statement, I think.
Let's have one more. This is excerpting Krugman:
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.
(3) For $100 - the preceding from Krugman is false.
In fact, low-growth scenarios with high stock market returns and an early distress for Social Security (Trust fund exhaustion by 2042 or sooner) are easily developed; high growth scenarios with low stock market returns and deferred trust fund exhaustion are also easily developed. In fact, although growth is an issue for Social Security (since the number of retirees doesn't grow, at least right away), it need not be for stock market returns.
Let's do (3) for $100, even though it is very close to (2). And I am not going to get all quibbly about folks whining "no fair, an income share of 11% is too high, Krugman didn't mean that, and it's not reasonable". He didn't say "reasonable"; he said it can't be done with low growth, and that only high growth led to salvation.
He also says that high growth scenarios improve capital returns, but that will only be the case if the income share to capital rises, or the relative level of capital deployed falls. And that is surely not what he said in the excerpt, where he talks only about growth. If Krugman will allow (by implication) a higher income share to capital in high growth scenarios in order to make his statement about higher returns true, then he must be willing to contemplate a higher income share to capital in a low growth scenario. Fair's fair. Let's play (3) for another $100.
OK, as I said, this is a fine chance for someone to commercialize their blogging, or blog-reading.
I would love to take people's $300. Dare I say, Bring it on!
MORE: Even though no one asked: I believe that growth is good, and that it is certainly easier to project high returns on capital in a higher growth environment; I suspect that the 6.5% real return folks talk about for equities is high; I believe that Dean Baker's fundamental point, that the Soc Sec Trustees ought to either explicitly forecast a return on capital, or back out the return on capital implied by their forecast, is excellent; I believe Oswald acted alone; and I believe that the Soc Sec Trustees have an institutional bias towards low-ball forecasts.
UNRELENTING: Dare we do equations? The formatting will be brutal, but why not? See the continuation.
Typically, they assume long-term returns of 6.5-7%, but returns like that are only feasible if long-term economic growth is also very strong. The problem is that if long-term growth is strong, Social Security isn't in trouble in the first place:
...Privatizers assume that stock market returns for the next 75 years will be as high as they have been for the previous 75 years. For that to happen, economic growth for the next 75 years also needs to be roughly as high as it has been for the past 75 years.
Well, well, well.
GDP = Output = Workers x (Output/Worker); Output/Worker = Productivity
Profit = Output x Income Share to Capital = Workers x Productivity x Inc Sh to Cap
Capital = Workers x (Capital/Worker)
Higher growth comes from adding workers (workforce growth), or increasing output per worker (productivity growth).
SO: Return on Capital =
[Workers x Productivity x Inc Sh to Cap] / Workers x (Capital/Worker)
Is it obvious that increasing growth by adding workers to this mix does not increase the
return on capital? Since "Workers" appear in the numerator and the
denominator, they cancel. This relects the notion that increasing the
scale of an operation does not change the return on capital (unless
something is *not* scaling the same way).
Productivity is trickier (and my verbal formulation may be off a bit).
Basically, as Output per Worker rises, the Capital team captures some
of the benefit. (Normally, I should add, productivity is associated
with "capital deepening", where it takes more capital to make workers
more productive. I am setting that aside here, since it makes it
harder for productivity to turn growth into a higher return on capital).
So, in this formula, if the old Return on Capital was 5%, and the
increase in productivity is 1.7%, the new Return on Capital will be
(5.0%) x (1.017) = 5.085%. Keep that up for 16 years with no capital
deepening, and the Return on Capital will rise to 6.5%. Patient
capital, indeed. And remember, we are assuming that, down in the denominator, (Capital/Worker) is not changing.
Suppose we increase Productivity so that it grows by 2.7% per year. Now,
the Return on Capital will grow from 5% to 6.5% in just 10 years. And when will it stop growing? Ahh, we have a bit of a glitch here - without some more elaborate assumptions about the relationship of capital to labor and output, the Return on Capital will just keep going up. However, any reasonable adjustment I make will slow the (already slow) improvement in the Return on Capital, so I stand by my point that the most plausible place to look for an improvement in the Return on Capital is not growth, but the Income Share to Capital. Increase the Income Share to Capital, and that can solve the Return on Capital problem right away.
As modeled here, higher growth achieved by adding workers does
nothing for the return on capital; higher growth through higher
productivity reduces the time it takes the return on capital to grow to
the target, with an unlikely assumption about capital deepening. So
yes, growth can solve the Return on Capital problem eventually,
depending on what one assumes about the relative capital deployed (as I