If Only The Times Had An Economist Who Understood Global Markets

Paul Krugman continues to assault both Social Security reform and his own professional reputation with his Tuesday effort titled "Many Unhappy Returns".  Let's excerpt a bit:

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.

...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.

I have just one word for the Earnest Prof - plastics.

Now I have another word - globalization.  For a fellow who hopes to win a Nobel Prize for his work in international trade and finance, Prof. Krugman seems to have become horribly absent-minded about his specialty.

Maybe I can help - the opening of global markets and global capital markets was supposed to be bad for the mill worker in Akron, who is now in competition with laborers from Mexico and China, but good for investors in Akron, who can now move their capital from Akron to Mexico or China.

In such a world with capital mobility, the return on capital earned by "US" investors will not be driven exclusively by the growth of the US market.  Oh, man, why am I even writing this?  Let me give the mike to Barry Bosworth of the Brookings Institute, who also took a stab at this "duh!"-inducing concept:

Alternatively, we could envision the extra saving being invested abroad.  In a large global economy with a growing labor force, the decline in the return to capital would be much less...       

I think that there is some appeal to a policy that tries to promote the expansion of global capital markets as an offset to population aging in the industrial economies....  The developing world will have a large potential to absorb capital in the future - first because the labor force will continue to grow in these countries, and second, because the capital per worker is still so low compared to the industrial countries.  So I think we can see some elements of a bargain between the industrial world and the developing world, that can resolve some of these problems in the future.

...I think that one further analogy that we might consider before we discount the notion of much more integrated global markets is that of in the United States. For a long time the US relied solely on local capital markets, then on regional capital markets; the move to a national capital market has been a relatively recent phenomenon.  Interest differentials between California and the East Coast did not decline to zero until somewhere in the 1970s. In prior years, there were large interest rate differentials between various regions of the country. Similarly, we now seem to be observing an integration of European capital markets at a fairly rapid rate. So one might be tempted to simply wait; as the markets to become increasingly sophisticated and able to deal with these problems, we will see an evolution to a more international capital market to absolve some of these problems.
       
Furthermore, we need not focus on increases in portfolio investment, and similar forms of investment, in these countries. The major mechanism that may be used in the future for channeling funds to emerging markets is direct investment by multi-national corporations. As the labor market continues to slow its rate of expansion in the US, Europe, and Japan,  enterprises in these countries are naturally going to turn to the developing world. So if we can tolerate the political consequences of increasing the 'multi-nationalism' of major corporations, (though the recent Seattle incidents demonstrated the strength of domestic opposition to this), that may become the major mechanism by which we try to integrate these markets in the future.

In summary, a global perspective suggests that the problem of population aging is easier to manage than is implied by the common focus on closed economies. Drawing a comparison to the US - for a long time we thought that New England was getting old, and California was young, and then a deal was struck between them: New England invested in California. Why shouldn't we think that the same process would occur globally? As Dr. Holzmann emphasized, there are currently significant barriers to the expansion of a global capital market, and we are still struggling to find the institutional arrangements that will make it possible. But past experience suggests that economic profit tends to overwhelm institutional barriers; and so, I would be optimistic in the long run about the potential for finding solutions to these problems.  I think multi-national corporations will prove an important part of the mechanism by which it's done.

No kidding - even though GE and Microsoft are "American" companies, they sell and earn profits abroad.  I'm reeling!

Now, a technical question about national income accounts - are profits earned abroad by US companies counted in US GDP?  I bet not.  But do they increase the value of my shares?  I bet they do.

Let's put it another way - Kevin Drum has some good background on the models forecasting lower growth, and the gist is that Output = Available Labor Force x Labor Force Participation Rate x Hours Worked x Productivity.  Fine.  And since the US labor force will grow more slowly in the future than it has up to to now, the growth in the economy will probably slow (productivity is a swing variable here).  Fine again.

But if we take seriously the implicit Krugman argument that equity returns must eventually track growth in the domestic economy, doesn't it follow that equity returns in Germany, Japan and France will be negative over the next fifty years?  Is that really Krugman's forecast?  Of course it is not - companies "over there" have lots of "foreign" operations [UPDATE:  Subsequent research tells me that, although these countries may see labor force shrinkage of less than 1% per year, productivity should grow by enough to assure growth in GDP.].  OK, now tell me why the methodology changes when it is the US on the examining table (Well, yes, we are a lot bigger, but does that invalidate the concept?).  While you are at it, tell me what Daimler-Chrysler is (and is it part of the S&P 500?), and tell me why US investors can't buy foreign stocks directly (the Federal Thrift Savings Plan, often touted as the model for the personal accounts option, offers a international index fund).

Maybe the globalization argument about mobile capital realizing leveled returns is all wrong - if the Times had a columnist who was willing to put his economics ahead of his polemics, the rest of us would know.

More: Andrew Samwick is in the mix.

Comments

[Forbes]

TM:
If Krugman were honest--a stretch, I know--he would become part of the conversation that illustrates what is wrong with the SS system, and therefore, point the way towards reform--including the direction in which he would prefer to see SS reformed.

Instead, he pulls elements of various proposals out of the air, and by way of debunking various straw man arguments, attempts to discredit the President's choice/privatization reform plan.

In this manner, he is leading the Democrats to their idealogical death as "status quo conservatives."

Lead, follow, or get out of the way.

[Ravi]

In other words, you are asserting that you believe the President's Social Security reform proposal is also a plan to cut our current account deficit? If we're seriously going to draw on foreign assets to fund future retirements we need to make sure that our stock of foreign assets is growing that the stock of foreign claims on the US economy - which, of course, requires current account surpluses, not deficits. Otherwise, globalization is a net lose in terms of the US economy's ability to fund retirements - money flowing out to pay foreign claims will be more than money flowing in from income on foreign assets. I could see making a case that the plan would move the current account in a positive direction if it (directly) increased national saving - but it doesn't. We already know the private accounts will be financed with debt, so they are a wash in terms of national savings. And that means that we should expect private accounts to do nothing to help the current account deficit, leaving a hypothetical future economy's ability to fund retirements unaffected.

[Buckaroo]

The savings rate in most of the rest of the world is much higher than in the US.

THe USA has been running a net capital deficit since 1980.

The idea that we could borrow some number of $Trillions (the President's report to congress said 23% of GDP between now and 2036, which would mean about $15 Trillion), much of it from abroad, so we can invest perhaps 10% of that back into international stock markets (few private investment advisors will suggest anyone should put more than 10% of their savings abroad), and have that save future retirees from a slow-growing US economy - when those future retirees depend on the US economy for the jobs from which to deduct the FICA taxes from which to make the contributions.

This formula basicly says to our kids, "sorry, the US economy is going to suck for the next 50 or 75 years, but the rest of the world is eventually going to catch up with us - particularly if you invest your payroll taxes abroad. And yes, you can increase your retirement savings by participating in this fantastic plan!.

I just can't imagine any US politician standing up on a podium and saying this, even if it were the best we've got to offer.

[TM]

...so we can invest perhaps 10% of that back into international stock markets (few private investment advisors will suggest anyone should put more than 10% of their savings abroad)

Who is "we"? Are you saying that, for example, GE has less than 10% of its revenue and income from foreign sources? Plenty of multinationals are considered US companies even though they have huge "foreign" operations.

Maybe the US is too big relative to everyone else, but the issue ought to be acknowledged.

[Jeff]

This is pretty absurd. We have so little reason to have faith in the economy of the "developing world," and I can't imagine why we would want to increse average American's exposure to the following representative phenomena:

1. China finally has the civil war that is inevitable in a society where the Tocqueville effect is running rampant, boys outnumber girls 3-2, and inequality abounds amidst an ideology that for 5 decades was firmly communist.

2. India... which may or may not exchange nukes w/Pakistan at any moment.

3. Africa, which the West destroyed by the creation of arbitrary "countries," and has been allowed to get worse and worse. ("positive stroies" about Africa... are way too high a proportion given the underlying realities)

4. Stable countries like Brazil and Argentina.

5. Stable democracies like Vietnam....

Yikes.

[Jim Glass]

I just want to note here for the permanent record that I took the "Baker test", that all the economists of the world have weenied out away from according to PK, earlier today over at Andrew Samwick's.

Lawyers have no fear. Economists are wusses.

And if the judges haven't been paid off I'll be expecting the trophy and prize check.

I note it for the permanent record here because, although it will be on my own blog tomorrow, things should be noted for the permanent record somewhere where people will read it.

[Brian]

Putting side the fact that nobody besides those who are already opposed to him for partisan reasons will give you more credit on economics than Krugman, I have to ask, why do you assume that he's only talking about the American stock market?

[TM]

why do you assume that he's only talking about the American stock market?

If he is talking about the global stock market, he concealed it as bit too carefully.

For example, this bit might be misleading, if he really had a global perspective:

The [Soc Sec] 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.

[TM]

I can't imagine why we would want to increse average American's exposure to the following representative phenomena:

Again, who is "we"? Krugman is arguing that US equities must grow in line with exclusively the US economy; I am wondering why globalization is not part of the equity return story.

That is a separate question from Soc Sec privatization.

[John Anderson]

Admittedly I have not read everything I have seen on this. But Mr. Krugman and others seem to be saying that since the market may grow at 2% or less, that is the Return-On-Investment to be expected by investors and thus dooms any private investment.

Uh, stocks and bonds pay out WHILE you hold them. Not just when you sell. The ROI may not be terrific, but it usually outdoes sticking the money in passbook savings.

Another admission: I would not trust myself to put in the effort to play the market successfully, so to that extent I agree privatization may be a problem. But that is, after all, why mutual funds were developed: like Vegas casinos, even an honest game gives the proprietor a good profit.

And even better for some, there are the tax-free mutual bond (rather than stocks or normal bonds) funds, or just buy them directly. A return of 3% on these may be better than a 10% return on others: it was for me when I was working, which is why I had bonds for a Puerto Rican dam project and others - no Fed, state, or local taxes.

[TM]

http://www.morganstanley.com/GEFdata/digests/20040903-fri.html#anchor1

A possible resolution - I continue to be troubled by the notion that equity investors in upstate New York (which has lost jobs and population for the last few decades) are doing less well than equity investors in NYC, which seems to be the obvious implication of the new "Globalization doesn't count:" theory.

Possible resolution - investors in Utica include small local businesses, but the S&P 500 does not.

Here is something from Morgan Stanley:

Two competing measures of corporate profits — the one from S&P and the measure in the national income and product accounts (NIPAs) — appear to be telling two quite different stories about the degree of deceleration. In fact, the stories in appropriately-adjusted data are essentially the same; simple comparisons between the S&P and NIPA measures are far from apples-to-apples: The former covers only relatively large companies on a per share basis, while the latter includes small and Subchapter S corporations in simple dollar terms. The former covers results from both domestic and overseas operations of US companies; the latter nets from that tally the earnings of US subsidiaries of overseas companies. Adding back such foreign earnings produces results quite close to the S&P growth rates.

Our forecasts are based on the NIPA metrics, while those of our colleague and equity strategist Henry McVey are grounded in the S&P measures. When corporate governance scandals tainted perceptions about the reliability of S&P earnings, many analysts began to look to the national income and product account (NIPA) measures of corporate profits as more reliable, because statisticians base them on tax return data. In fact, neither is more reliable than the other; the most recent three years of NIPA corporate profits are based on company reports, because tax returns are only available with a three-year lag. Comparing forecasts based on these two metrics, as we do, does serve as an important cross-check on our outlook.

Developing...

[Brian]

"If he is talking about the global stock market, he concealed it as bit too carefully."

Perhaps he felt that it wasn't going to change anything in a significant way. It's far from certain how the growth of economies around the world will affect us.

Do the trustees place a lot of emphasis on global markets?

---------------------------------
"Krugman is arguing that US equities must grow in line with exclusively the US economy;"

Or so you assume.

"That is a separate question from Soc Sec privatization."

If you are referring to returns, which is the only thing that makes sense, then no, it's not. That is the debate, or at least what it should be.

[TM]

Brian, if you are seriously arguing that both the Social Security trustees and Paul Krugman are discussing the projected performance of the global economy, I would suggest you re-focus on what are undoubtedly stronger arguments.

As to the notion that a discussion of the long term link between share price performance and the US economy can only occur in the context of Soc Sec privatization, that is even more absurd.

[Greg D]

For someone who is supposed to be an economist, Krugman sure is clueless.

Let me se if I can get the concept in terms anyone can understand:

You cannot consume goods that aren't produced.

Doesn't seem that revolutionary of a concept, does it? But it's the downfall of Krugman's whine. Because when you want to start consuming, it doesn't matter how much money the country has "saved", what matters is how many goods and services are available.

IOW, what matters is the size of the economy.

If we have a $10 Trillion economy in 2042, a certain percentage will be available to retirees. If we have a $15 Trillion economy, that same percentage will be worth a whole lot more.

If we have SS privitazation, we will have money that can be invested, NOW, in growing the economy. Some of those investments will be bad. Others, if history is any judge, will be good, and will lead to the economy growing.

If we have SS privitazation, then instead of having 15% of their income being taken to drop in yet another governmental hole, people will see some part of that dropped into their own personal account, which they will own, and control.

This will make "working" more valuable. Which is to say, we can expect that one effect will be to increase labor market participation. (If I understand things correctly, you don't get more from SS for working 40 years than you do from working 20. However, you WILL get more from your private account for working 40 years than from working 20.)

One last point: I'm curious, has anyone done a comparison between the amount of money President Bush's plan would add to the stock market, per year, compared to the amount of money existing pension plans add to the stock market each year?

Did 401Ks destroy the stock market's rate of return?

[GT]

Whoa. Are you seriously saying that we can make up for lower equity growth in the US by investing in Mexico?

[GT]

Greg D,

If you read what has been leaked there is precious little control.

[TM]

GT - No, I am not Barry Bosworth. I am saying that a fellow who made his name as an expert in globalization might want to devote a sentence to explaining why it is now irrelevant.

[GT]

Tom,

It's a fair question to ask what the impact of overseas investment would be. I don't know the answer. Krugman's column is only 700 words long and there is only so much he can write. But he will be writing a lot more on SS so if you or othewrs email him there is a good chance he may address this in the future. He has done that before (respoond to requests, that is).

I suspect overseas investment will help, but not that much. The other economies that are large enough to absorb such investments are not growing that fast either and have even greater demographic problems than we do (EU, Japan).

Other economies that are growing fast are still comparatively small. Plus any overseas investment would have to account for growth volatility, which is huge in emergung markets, and exchange rate risk. It's no good investing in a local market if a devaluation wipes out your dollar gains.

Finally GDP does not include earnings of US companies abroad IIRC. That's in the GNP calculation. But don't forget that foreigners are also earning here and taking their money out.

[TM]

Hmm, if you think that being all reasonable can make me feel like a jerk about my previous snark, well, its working.

I have two thoughts about the possible impact of foreign earnings:

(1) there can't be more than a thousand Wall Street economists who have thought about this - the Morgan Stanley bit I excerpted above can only be the tip of the iceberg.

(2) it is *highly probable* that the GDP "profits" figure includes all sorts of local small businesses not normally associated with the S&P 500, or even the broader stock indices. Not having researched the ratio, I can only speculate that even if total profits grew slowly, S&P 500 profits might have room to grow rapidly if they are a small part of the total profits figure.

In that scenario, the share of profits going to big companies with big overseas profits would rise, as would their shareprices, even as total profitswere stagnant.

However, I have decided that I am off on a tangent (boy, is that a familiar feeling). Andrew Samwick has the real rebuttal, and the more I reflect, the more I realize that he is right (PGL has the same theme, the gist of which is, growth in profits is different from return on capital). In fact, what is stumping me now is figuring out just how to present the way in which Dean Baker went wrong.

I will be curious to watch the climbdown, because at this point Max Sawicky, Dean Baker, Paul Krugman, and (IIRC) Brad DeLong have all hitched their wagons to a falling star.

Or I have...

[GT]

Having quickly gone through the links you provided I too am interested in how this will pan out, intellectually. Samwick's argument of an increased % of dividend pay outs seems a bit made up for me. I saw no logical reason for that to happen. But maybe more arguments will be forwarded.

Same with your "Increased share of S&P500 profits of all corporate profits" argument. Why would this happen? Why would, all of a sudden, publicly traded companies start consistently and over several decades oput performing privately-held firms? At some point that would mean that pribvately held firms would have to simply disappear which makes no sense.

[Jim Glass]

"I suspect overseas investment will help, but not that much. The other economies that are large enough to absorb such investments are not growing that fast either and have even greater demographic problems than we do (EU, Japan)."

~~~
We are talking about *75 years* as per the Dean challenge.

China's GDP overtakes the US's in 15 years. Then the US drops into low-growth 2% mode. What will be the ratio of Chinese-to-US GDP 60 years after that? Well, 3 or 4 to 1 is entirely plausible.

Is anyone investing in China yet?

Look at an atlas. There are another 3 billion people in other countries, not including China, that are fast-devloping and counting on growing a lot faster than 2% for the forseeable future. (Versus 300 million people in the US.)

If their growth rate is a very conservative 1.5 percentage points faster than the US's over 75 years, they will triple in size relative to the US. Then add China to them.

How is the share of foreign profits of US business supposed to not grow in such a world?
~~~~

"the gist of which is, growth in profits is different from return on capital"

Sure. Firms invest in the economies that grow biggest because that's where the most profits are (pursuing the highest marginal profits for the firm). Average profits across markets will equalize.

But being that returns across markets equalize, here's a question for Dean/Krugman:

Lets accept that GDP growth rate determines the growth rate of profits.

In a world with say 4% GDP growth setting the growth rate of world corporate profits at 4%, why would US corporate profits grow only 2%? A return to isolationism?

[GT]

Jim,

Maybe, maybe not. It's way too iffy to bet our SS system on that. And did you take exchange rate risk into account?

And do you think the US will be OK if 50%+ of our retirement depends on China, no matter how big it is? That's simply ridiculous.

[Patrick R. Sullivan]

"Samwick's argument of an increased % of dividend pay outs seems a bit made up for me."

How about a historic reason?

"Same with your 'Increased share of S&P500 profits of all corporate profits' argument. Why would this happen? Why would, all of a sudden, publicly traded companies start consistently and over several decades oput performing privately-held firms?"

Don't they already? 'All privately-held firms' includes the ones that start up and then fail, which is to say the majority of them.

Btw, Mexico is exactly where I would expect a lot of investment to go. Vincente Fox does too.