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February 09, 2005



To get profits share of the pie expanding don't you have to assume a sharp drop in competition. The way the system works is that rates of return are what determine where investment occurs. If an industry has superior returns capital flows into that area until returns fall back to "normal" , average levels. The long run history of free markets is that superior returns are unsustainable.


I must be misunderstanding your model. Tell me if this is what you meant:

Returns on stock = return on capital.
Return on capital at a P/E of 20 is 5%.
GDP growth does not affect the return on capital.
Therefore, GDP growth of 1,000,000% (or .000001%, or potentially even -99.9999%) will lead to returns on stock of 5%, all else being equal.

Is it really your position that GDP growth has no effect on the returns provided by stocks?

Patrick R. Sullivan

'To get profits share of the pie expanding don't you have to assume a sharp drop in competition. The way the system works is that rates of return are what determine where investment occurs. If an industry has superior returns capital flows into that area until returns fall back to "normal" , average levels.'

Well, Krugman is assuming a DECLINE in rate of return, only a small part of which could come from more capital chasing fewer American workers. He's positing 'mathmetical impossibility' of maintaining current ROI, due to slower GDP growth.

Obviously, if that happened, then Americans would look outside our borders for investment opportunities, in a process developing over several decades. We get a lot of our food, clothing, autos and trucks, televisions, cameras, furniture, from people beyond our borders. Why not some of our investment returns?

creepy dude

"There is no trust."

-President Bush 2/9/05

fred c. dobbs

You must be feeling very proud of yourself. I agree that your scenario is mathematically possible, in the same way that flipping heads 10 billion times in a row is possible. You have succeeded in showing Krugman's rhetoric to be overstated. Good for you!!!
But what about the larger point? Is it plausible that stocks can return 6.5% consistently with GDP growth of less than 2%?
History shows that your scenario of 7.3% AVERAGE capital/income ratio for the next 75 years is extremely far-fetched.
Capital's share of income has reached 7.3 percent only 20 times in the last 231 quarters, usually in periods of extremely high productivity growth (including the last five quarters). In only 2 of those quarters with high capital-to-income ratios was GDP as low as 2% (both in 1949). In other words, you assume that something that's happened less than 1 percent of the time in the past will suddenly become the NORM over the next 75 years.
It looks to me like a high capital-income ratio in a time of low growth is inherently unsustainable.
Even if it weren't unsustainable in economic terms, it's unsustainable politically. You think voters would keep electing Republicans if wages were stagnant for 75 years?


Is it really your position that GDP growth has no effect on the returns provided by stocks?

Defies your intuition, doesn't it?

Was there something about the math that puzzled you, though? If my return on capitalis 5%, and I double my business, that is 100% growth. What is my new return on capital?

What I really think it that new profit opportunities are more likely to occur in environmernts where the economy is changing rsapidly. Normally, that would be associated with high growth, so yes, I think we can reasonably expect that, looking backwards, we will see a correlation between growth and returns.

But you can buy a T-bond right now and earn 4.5% on your capital for 30 years. No growth, though.

Fred - thanks for the extra analysis - one almost thinks you read this.

First, at the bit where I said that this was not my "most likely" forecast - maybe I should have emphasized that this is not my most likely forecast.

Second Corporate taxes are historically low, and by all estimates going to get lower. In your past historical analysis, did you assume lower taxes?

In the chart I posted, pre-tax averaged 8.5% of GDP / subtract taxes of 1.5%,and you have 7%.

Finally, as to You think voters would keep electing Republicans if wages were stagnant for 75 years?

To clip labor down by 1.1% of GDP means they forego about *one* year of productivity based raises. After that, their real wages resume rising with the economy, consuming 56% of GDP. One stagnant year, not 75. Unimaginable? Read your Krugman - it happened.

Jim Glass

I don't know why I should help you claim a prize that properly belongs to me, but here's the Council of Economic Advisors thumbing their noses at Krugman & Baker (I guess they do read the Times)...

Are projections of future stock returns realistic given the outlook for long-term economic growth?

Yes. The Social Security Actuaries assume that stocks will provide an average real return of 6.5% per year over the next 75 years.

Some argue that this is unreasonably high if, as the Social Security Trustees predict, economic growth will average only 1.9% per year in the future.

This argument is incorrect; the stock return and economic growth assumptions are not inconsistent.

The Actuaries' financial assumptions are consistent with historical experience and other professional estimates... [examples]
The Trustees predict that economic growth will slow primarily because of slower population growth. Slower population growth need not imply lower stock returns.

The Social Security Trustees project that economic growth will slow in the future, primarily because of slower population and labor force growth. Some observers believe that this growth slowdown will reduce future stock returns.

Although short-run movements in growth can affect stock market returns, there is no necessary connection between stock returns and economic growth in the long run.

Long-run economic growth is determined by productivity growth and labor force growth here in the United States, while stock market returns are determined by the overall cost of capital in the global economy and by the return investors require to bear the risk that comes with equity ownership.

There is no reason to believe that slowing population growth in the United States would significantly lower the cost of capital, as set by increasingly globalized capital markets, or the premium required by stock investors....


There are those global economy and globalized capital market thingies again.

Maybe Krugman should have checked with an international economist instead of DB?

(How many times can we take that shot? Lots!)


Ok, I am not an economist but...

In your model aren't you assuming that a reduction in costs translates directly into an increase in profits? In the real world doesn't this only occur if your competitors do not share in your cost savings?


OK, I am not an economist but...

Noah, step up - I am not either (although I have a finance background).

I am essentially surfing on the point that Jim Glass elucidated in his earlier comment - if the equilibrium return on capital is 6.5%, competitive pressures will not drive returns lower.

Now, if the equilibrium *really is* at 5%, then my model breaks down. But if firms really are targetting a higher retrun than theyarecurrently earning, they will do things like try to gold the line on wages.

If their competitors are feeling similar pressure to bosst *their* returns, "everyone" will hold the line on wwages, and the return on capital will rise.

But you are right that I can't walk into my (hypothetical) business tomorrow, announce that my new target return on capital is 15%, and cut everyone's wage - in a competitive market, they will find jobs elsewhere.

Jim, thanks very much for the CEA link.

Paul Zrimsek

If the rate-of-return issue were one we could solve simply by looking at history and applying persistence, the debate would be over before it began: the historical rate of return is over 7%. The very reason we're even talking about all this is that things are likely to be different in the future-- and the relationship between growth and return on capital is one of the things that we can plausibly expect to change, given that (as I mentioned in comments to an earlier post) the central fact of the SS debate is that the future will bring us an increasing number of retirees who are no longer contributing their labor to the national economy, only the continued use of their capital. I believe that under these conditions, any argument for significantly reduced returns for equities which depends on the assumption that capital's share of national income will remain unchanged verges on circularity.

Don Garber

From your column:

I would be delighted to explain.  Let's get some starting numbers.  In the column we are given an initial P/E ratio of 20, for an earnings yield, and implied return on capital, of 5%.  Our target, also per the column, is a return on capital of 6.5%, which is 30% higher.  Prof. Krugman implies that we need to grow our way there.

But hold on.  Return on Capital is simply [Income / Capital].  To grow this ratio, I must somehow grow Income faster than Capital; any equal growth rate will simply preserve the ratio.  Bit of an impasse.

Let's try a different perspective, and express both Income and Capital as a percent of Gross Domestic Product.  Here we go:

[ (Income/GDP) / (Capital/GDP) ] = 5%; we want to grow this to 6.5%.

Unless I have forgotten my math,
(Income/GDP) / (Capital/GDP) = Income / Capital
so I don't see the point of using percentages.


The real issue here is that you're assuming without proving that the assumed xx% return on capital is a compound return; that the income generated by the capital earning your rate of return on capital can be reinvested at the same rate of return. It needs to be a compound rate, because we're talking about 6.5% compound on equities and we don't want the PE ratio to explode.

But it seems to me that you're explicitly assuming that the income generated in your model is *not* reinvested in more of the same kind of capital. Because otherwise, reinvesting the earnings (either in the same firm through retentions or in a different firm via dividends reinvested in new equity issues) at 6.5% would give a much higher rate of growth of GDP.

Remember that the Modligliani-Miller result is based on an arbitrage argument, which means that you can only apply it in contexts where it's safe to assume that there is perfect substitutability. Dividend policy doesn't matter in MM because it's assumed that you can synthesise your own dividend policy by reinvesting the dividends or by realising capital gains. Which is possible for any one investor in a company, but is not possible for the market as a whole unless you can find some set of assumptions which makes it plausible to regard a broad-based US equity index as a small part of the total capital market (Patrick and Jim occasionally suggest this, but I'm not convinced).

Or to put it another way; if you were the only person in the world who could own equities, and you owned 100% of the stock of the only company in the world, then that company's dividend policy would matter one heck of a lot for your wealth in 50 years; it would determine whether your profits were compounding or not.



I think where part of my confusion lies is where you subsitute return on capital for return on stocks. If I own 1% of a company's stock, and that company accquires more capital without issuing more stock, that company's earnings will increase, and the return on my stock will increase, but the company's return on capital will remain constant. Conversely, if half of the companies in the stock market disappeared tomorrow, taking their income and capital with them, the average return on capital wouldn't change, yet I'd expect the average return on stocks would suffer a bit of a drop.


What about the possibility that Krugman is vastly overstating the "do nothing" situation? We are currently using social security as a piggy bank to fund spending. Once the piggy bank is gone, the government will have no choice but to flood the market with 10 and possibly 30 year notes.

As a result, interest rates will soar. This will hurt the financial markets and stagnate GNP growth. It will also "crowd out" investment away from the private markets. Capital starvation will result.


D-squared - my main reliance on the MM theorem is the idea (not really explained) that companies (or the corporate sector as a whole) will "dividend out" any cash they can't profitability re-invest.

Hence, if the economy grows slowly, and there are no obvious re-investment opportunities, they simply don't re-invest; the capital base also gropws slowly, and the return on capital remains at the target level.

In that case, neither profits nor dividends will be growing rapidly, but the return on capital will be fine. Sort of like a value stock.

Don Garber, who worries that he has forgoten his math -

If you put the fraction as (Income/Capital), the question becomes, why will income grow faster than capital? Sort of an interesting question, with no obvious answer.

If you put the same question as two fractions, you then have two questions - why will the (Capital/GDP) ratio *fall* over time, or why will the (Income/GDP) ratio rise?

Split that way, the issues struck me as being more clear. And the (Capital/GDP) falling as we add workers story doesn't make much sense - new workers need new capital (and in Dean baker's model, they got it, at the same ratio as current workers).

Zarquon - I am with you as to your 1% ownership example - what you seem to be saying is that a company could retain it's profits and reinvet them at the target return on capital, in which case you would get no dividends, but retain1% ownership in a company with a larger capital base. We agree.

As to "half of the companies in the stock market disappeared tomorrow, taking their income and capital with them", well, that depends on how they disinvest, I expect.

Obviously, overnight is extreme. But a particular copany could find itslef in a no-growth mode, and didvidend out all profits. And if the situation was poor enough, it could stop reinvesting to cover depreciation - in that sense, it would dividend out (profits + depreciation), decline to replace its capital base, and slowly liquidate.

Whether it could do that while maintaining a target return on capital obviously depends on the circumstances that prompted it to leave the market.

But at least conceptually, the "wasting asset" is not a problem - oil wells come to mind, since they (presumably) provide an adequate return on capital even though eventually they go dry.

People don't normally think of high returns on capital in conjunction with a shrinking asset, but that doesn't mean it can't happen.

And in the model above, we aren't even talking about a shrinking economy - it is justgrowing more slowly.

Patrick R. Sullivan

"...if you were the only person in the world who could own equities, and you owned 100% of the stock of the only company in the world, then that company's dividend policy would matter one heck of a lot for your wealth in 50 years; it would determine whether your profits were compounding or not."

You could start a second company, or expand the one you have with the dividends. One thing for certain in your set-up is that the share price won't ever change.


You could start a second company, or expand the one you have with the dividends

Which would presumably show up in the GDP. Krugman isn't saying "no growth", he's saying "no growth without growth".


In that case, neither profits nor dividends will be growing rapidly, but the return on capital will be fine. Sort of like a value stock.

Yeh but there is an issue of composition here. Value stock investing works because the investor can compound his returns by using the cashflow to buy more of the asset. At the whole economy level you can't make that assumption without affecting what you're saying about GDP.

What I mean here is that when Bill Miller reinvests his dividends, it doesn't necessarily have any effect on the GDP, because he is for the most part buying already existing equities on the secondary market. But "the market as a whole" can't reinvest by buying stocks on the secondary market; who would they buy them from?[1]. "The market as a whole" can only reinvest its dividends in newly issued stock; either IPOs or seasoned equity offerings.

But if you're buying stock in new companies or financing stock issuance by existing companies, then those companies are selling you shares because they want to do something with the money. Specifically, they want to buy more capital assets and use them to produce goods and services. Which means that GDP grows, hurray. This is why it's difficult to get a compound return of 6.5% without also assuming GDP growth higher than 1.9%.

And as I say, it has to be a compound return that we're interested in. The basic idea here is that you have to model the effect of reinvesting profits on the economy; to do otherwise (which I would argue you have to do in order to get the low growth/high returns outcome) is to commit something like the mirror image of James Glassman's fallacy; rather than double-counting dividends in the returns forecast, you're under-counting them in the GDP forecast.

[1]Foreigners, potentially, and the introduction of the international dimension both complicates and weakens Krugman's argument. But to assume that the potential for international investment can make a material difference seems to me to have the implication that US retirement savings are small compared to the global capital market, and they aren't.

Dick Thomma

I'm not an economist, but this is a pretty weird model that went way off track somewhere.

The rate of growth of the stock market, I would think, is some proportion (less than 100 actually, but for this post we'll just forget that) of the rate of growth of total profits throughout the economy.

If the economy is growing at a steady rate, both wages and stock payments can grow at the same rate as the economy without any stress.

But if the economy is not growing, the rate of increase of stock payments has to come out of wages _every year_.

Can economic growth be confined to just profit for the next 75 years?

It sounds really hard. It sounds pretty close to mathematically impossible.

I don't think the "No Economist Left Behind" cup can be handed over just yet.

If we are talking about 6.5% rate of increase of stock payments every year with the entire economy growing at 1.9% every year, 1.9% of the rate of the increase of stock payments can come from neutral growth and 4.6% has to come from taking growth that would have gone to wages.

If wages are about twice stock payments, then wages giving away their neutrally expected 1.9% growth in wages lets stock payments grow by another 3.8%. So the last 0.8% of stock growth has to come from _declining_ wages.

Ok. So wages can decline by 0.4% per year every year from now on, and the economy can grow by 1.9% and profits can grow by 6.5%. At that rate wages fall in half every 175 or so years.

We're saying here that all profits in the economy are stocks, but since they are not, wages have to decline even more.

Reasonable? If this is how to save social security, a safer bet is just that the Trustees are underestimating economy-wide growth - in which case, as Krugman is saying, there is no crisis.

Have wages ever declined in any industrial country for 50 years?

It may not be mathematically impossible but it's damn hard.

And as Delong points out, the Trustees assume a stable capital to wage payments ratio. Given those assumptions we are back to full fledged mathematical impossiblity.

But thanks for playing.

It seems that there is a substantial chance that Krugman is right and MacGuire is wrong.

If that ends up being the case, will MacGuire recant? Maybe Krugman would not have recanted if he had been wrong. Is MacGuire a bigger man than Krugman?

If Delong gives this as a problem set to an undergraduate macro or principles class at Berkeley, I wonder how many of the kids would be able to find the error?

Dick Thomma

Is this providing a helpful shorter summary of the previous post or just piling on? I don't know.

But if I own stock that represents .00001% of America's corporate profits, then for my stock to increase by 6.5% per year the value America's corporate profits has to increase by 6.5% per year.

Can the value of America's corporate profits grow by 6.5% per year while the economy as a whole grows at 1.9% per year? For a long time?

Mathematically impossible if you assume the capital to labor ratio will remain constant.

Impossible as a practical matter if you don't make that assumption.

No "No Economist Left Behind" prize for Tom MacGuire.


Dick, return on capital is static. It's not 6.5% growth in earnings. If stocks paid 6.5% dividends annually, you would have 6.5% return on capital. Tom is talking about a one-time increase in the income share of capital from 5% to 6.5%. That could be accomplished, in theory, by one or two years of GDP growth with no wage growth. After that, stock returns and wages can continue to grow at the same rate as GDP.

Mark Bahner

"And I suspect that at least some privatizers know that. Mr. Baker has devised a test he calls "no economist left behind": he challenges economists to make a projection of economic growth, dividends and capital gains that will yield a 6.5 percent rate of return over 75 years."

I made projections of economic growth that would yield a rate of return of ***over 10 percent*** over the next 75 years:

http://markbahner.typepad.com/random_thoughts/2004/10/3rd_thoughts_on.html>3rd thoughts on economic growth in the 21st century

Note: My projections were averages for the *world,* but I think the U.S. will have an average economic growth that will be close to the world average.

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