Powered by TypePad

« We Move Towards The "Hummina Hummina" Moment | Main | Does Your Model Have HAIR? »

February 10, 2005



The ss projection assumes 1.5% productivity compared to a post WW II productivity growth of 2.5%. When I look at the data that looks as if it is as big a reason for slower growth than the slow down in hours work growth from around 1 % to 0.2% they assume.

Assume> 1.9% real growth
market pe constant and dividend yield 2%.

To get a real stock market return of 6.5% profits share of the pie would have to increase many fold -- something on the order of 4 to 6 fold. Since WW II after tax profits averaged 6% of nominal gdp. Since 1964 -- as far back as I have data --- S&P 500 earnings have averged 3% of gdp.

Do you really accept that profits share of the pie would rise to a quarter to a third or more of gdp?


From 1948 to 1975 productivity growth was 3.0%.
From 1975 to 1995 it was 1.5%
From 1985 to now it has been 3%.

By selecting the period since 1966 to calculate productivity growth the CEA is giving greater weight to the low productivity years and so is creating a downward bias to their productivity history of about a quarter to a half percentage point.


The CEA defines bankrupt as having insufficient assets to cover ones debts. OK, I'll buy that.

The primary asset of the US government is its power to tax. So as long as social security debts are less then 100% OF GDP -- the upper limit on taxes --the social security system can not be bankrupt.

Isn't this a stupid argument?



SS has no debts so it can't go bankrupt. Right there the CEA starts making things up.

As for this white paper Brad Delong addressed it several days ago pointing out that the CEA's math only made sense if they assumed a 60% drop in stock prices.



Do you really accept that profits share of the pie would rise to a quarter to a third or more of gdp?

Would you care to attempt to relate that question to the Dean Baker method of calculating return on capital described in his 1999 letter to Feldstein?

Otherwise, all that happens is people end up muddling "growth" and "returns" until they are hopelessly confused.

If, for example, future growth is going to be slower, than the need for future reinvestment will also be lower, and dividends will be higher.

An assumption that implicitly assumes a rate of reinvestment based on past growth, but a smaller economy based on slower growth, inevitably produces the sort of train wreck you mention - all that reinvested capital "must be" producing profits that dwarf GDP.

Increase the dividned rate, reduce the rate of reinvestment to match the new economy, and the problem is solved.

Meanwhile, you have not addressed my very simple math problems (currently Number 1-4 on my as-yet-unpublished "Frequently Unanswered Questions"):

Dean Baker says that returen on capital is Profits/Capital (this is not widly controversial, BTW).

SO, why, in a higher growth economy, do Profits grow faster than capital? If they grow at the same rate, the ratio won't change?

Related questions: Rewrite Return on Capital as:

[ (Profit/GDP) / (Capital/GDP)]

For the return on capital to fall, either (a) the Capital/GDP ratio must *FALL* over time, or (b) the Profit/GDP ratio must rise.


(2) Why do we expect the Capital/GDP ratio to fall over time? Is that the history of economic growth?

(3) Why will the Profit/GDP ratio rise in "high growth" scenarios in a way that it cannot rise in "low growth" scenarios?

(4) I provided what seems to me to be a perfectly plausible scenario explaining how the profit share of the corporate sector could rise even with low growth. Can you explain why (a) that scenario is not plausible, and (b) why we should expect the Profit/GDP ratio to rise in your high growth scenario?

Thanks very much.


Hi Tom. First, I was curious if you automatically got these trackback and ping thingies when I linked to your definition of the Notional Offset in a diary at another site. Just curious. Of course, I prefer the more descriptive phrase "Social Security clawback". My diary wasn't very popular because I tend to be too wonkish for most folks and I'm not even in the same league of wonkishness that some of you folks are operating at.

I've been following your Krugman discussion with moderate interest. Maybe I don't qualify as a lefty, because I am not at all concerned if Krugman made a mistake. On the other hand, maybe that makes me a lefty. I've really been trying to figure out why this is such an important point. It looks to me like Bush has already admitted defeat on mathematical grounds when he admitted that privatization would do nothing to solve the unfunded liability crisis.

Help me out here Tom. I'm not trying to be contrarian, I just really don't see the significance of this point. Isn't Social Security, at its root, now a PR battle? If I favored privatization I would be far more concerned about recent polls that show a large majority of Americans favor lifting the cap on S.S. deductions entirely. That is a level of economic confusion that amazes me.

Has anyone even bothered to figure out how much money S.S. would bring in if every income in America was taxed 6.2%? Or, even scarier, do most Americans seriously believe we should tax every income 12.4%? A millionaire would pay $60k every year at 6%, or $1.8 million over 30 years. Just off the top of my head, I would guess that a 6.2% tax would raise between $500 billion and a trillion dollars every year. Is that right? Maybe more? Whooooeee! Some fun now! Pork barrel spending and trust fund I.O.U.s galore!

Now that's what I call a luxury retirement tax. We could raise S.S. benefits to what, $50,000 or $60,000 a year? More? How much money would Bill Gates pay every year if he had to pay a 6.2% Social Security tax? I stopped by dkos the other day and just shook my head that they considered lifting the cap entirely a serious proposition.

I may look up the numbers and try to make some calculations this weekend, but probably not. You and I may disagree about personal accounts, but I suspect we have common ground on the idiocy of raising taxes 6.2% across the board for incomes above $90k. Not that Congress would have any trouble finding worthwhile projects to spend it on.


I'm not trying to be contrarian, I just really don't see the significance of this point.

Jolly, you had me with hello. My first post in response to Krugman's column (I have been obsessing, but I hope to stop soon) was titled "Krugman Versus The Strawmen", and made the point you made here - Krugman is rebutting an argument about high stock returns that no one is making.

As to why I am obsessing, I started blogging as an alternative to geting red in the face and pounding my kitchen table twice a week when Krugman's columns came out, and for nearly three years I have had to listen to "He's a Princeton Prof who will get a Nobel Prize in Economics, what could you possibly know?".

So later today, if I spike an economics textbook on the ground, put my foot on it, and start flapping my arms like an eagle, well, its been a good week.

Well. As to uncapping the payroll tax, I agree that that is a weirdly unserious idea. But it is one reason I really wonder where Bush thinks this is headed - eventually, Dems will hit on ideas that make sense: tax some generally agreed-to-be-bad thing, and dedicate the tax receipts to saving YOUR RETIREMENT! Then we will see whether Reps can resist the newfound public desire to raise taxes.

So, instead of a payroll tax, Dems have talked about dedicating receipts from the estate tax to saving Social Security. Or a national liquor tax, or a cigarette tax - that sort of thing.



I haven't seen you address Brad's point that the CEA numbers only make sense if the stock market crashes.

What do you think of that?


GT - now that I have read the Brad DeLong post (and thanks, I was wondering if he had seen the CEA press release), what did you think?

I am just in shock, and I want to find a way to express this without the customary snark (and the strain is killing me) - his analysis is deeply flawed. However, it is deeply flawed in the same way that Spencer's is, and taken together, they are quite illuminating.

I have been spending some time figuring out the return on capital puzzle as Dean Baker modeled it (Income/Capital, pretty heavy stuff). I have not really focesed on the Spencer-DeLong method, although it seems to be widely popular. However, a dressed up version of the quick explanation I gave to Spencer may illuminate the point.

Let's call this the Fallacious Hidden Assumption of Impossible Reinvestment. What happens is, people make a hidden assumption about reinvested earnings and compound growth that leads to a train wreck down the road (in Spencer's example, profits grow to become equal to GDP).

Since they know the train wreck is wrong, they (correctly) judge that one of the starting assumptions must be wrong.

But then *they change the wrong assumption*, by concluding that the return number was off.

A quick illustration - imagine BigCo is 1% of GDP, and has a return on capital of 21% (wow!). Can it keep this up for 30 years?

NO, says Spencer - If BigCo grows 20% faster than the economy for 30 years, it will go from 1% of GDP to 70% o f GDP, and swallow the economy. Ridiculous! The 21% must be wrong.

Not so fast,say I - the hidden assumption in this example is that the dividend rate is 0%, and that BigCo attempts to reinvest its profits at 21%.

Suppose BigCo pays out 100% of its profits as dividends - now, its profits won't grow, its capital base won't grow, BigCo will actually *shrink* as a percent of GDP - but investors will get 21% for 30 years.

That fallacy - that what is not paid out as dividends must be reinvested, leading to growth results that are nonsensical - is the error behind Brad DeLong's post, and Spencer's earlier example.

For example, historically, GDP growth was 3.5%, dividend yield was 3%, equity return was 6.5% (roughly, I am going on memory here). People say, well, going forward, growth is 1.5%, the dividend yield is 2% - if the return on capital is 6.5%, profits grow to an absurd level of GDP.

Yes, they do, just like BigCo swallowed the economy - the reinvestment assumption is too high. Bring it down, and all is well - with 1.5% growth, companies earn 6.5%, pay out 5%, expand their capital base by 1.5% (with the economy), new profits grow by 1.5% - no train wreck, life is beautiful.

Now, folks say, we can't have dividends that high, that is not the historical ratio. So what? Growth is at historically low levels, might we not consider the possibility that new investment will also be reduced, and dividends raised?

Brad DeLong's argument is that rather than predict higher dividend payouts tomorrow, we must predict a stock crash today, or lower returns tomorrow, or faster growth tomorrow. Huh? Bit of a false choice.

And beyond that, the basic premise is that "the economy" is only growing by 1.5%, so companies run out of things to do with their cash. In my simple world, the solution is that they just dividend it out. In the real world, there are investment opportunities all over the world - rather than pay out more dividends, US companies may invest the excess cash abroad, or pay down debt. The investment opportunities of US companies are *not* limited by the growth of the US economy.

So, where Brad DeLong sees a stock market crash, I see a combination of higher dividends and increased foreign investment. If I had to guess, it would be foreign investment.

Now, an honest moment here - I really am right about this, and, (this may be controversial) certain aspects of math are true even if a Republican says them. Can this many people really be this wrong?

Now, some of the folks agreeing with the crash scenario are just the pure bears, looking for reasons that the stock market must crash. But I seriously think that people believe this stuff - that lower GDP growth and lower profit growth must mean a lower return on capital, when all it really means, as with BigCo, is that you grow your capital base more slowly.

Anyway, you guys are scaring me. You really are all wrong, and I am right. But that is what every lunatic says. Troubling.

OK, I need to boil this down, and pester some folks. Thanks very much.

Oh, and if anyone wants to bring me back to their version of sanity, feel free. Or, if it has dawned on someone that I am right, let me know.

Not that it matters - I am. Weird.


JollyBudda - my understanding is that the current cap on FICA captures 85% of income.

So removing the cap completely would increase revenue about 17%, except that a lot at higher incomes would further shift wage income to other forms of compensation. That would be sufficient to more than cover the full projected shortfall in SS over 75 years.

The Greenspan Commission in 1983 set the cap so it would capture 90% of income. If the cap was adjusted back to that level, it would cover something like 40% of the projected shortfall.

And hey, you missed Brad Delong's comments on the CEA propaganda piece. Sure, investors will demand 6.5% returns ... but can probably only get them on the US market if the market tanks first.


But if BigCo isn't getting any bigger, then investors will just bid the price up once, to bring the yield down to the average.

We won't all be able to own BigCo, at least not more than a couple shares. And presumably, sooner or later, BigCo will pull a (Krispy yumm!) donut on us.

If BigCo can't reinvest its earnings profitably, I don't think they can save us. They can do quite fine for the insiders and early investors, but they can't feed 70 million retirees.


so where were the Frequently Unanswered Ques...oh, now I get it. So tricky.

Jim Glass

"And hey, you missed Brad Delong's comments on the CEA propaganda piece."

DeLong didn't have any comment at all on the CEA propaganda piece.

He totally ignored what it actually said, and simply repeated what he'd said before -- just as if repeating oneself serves as proof that one is right, and ignoring criticisms of what one has said is proof that they are wrong.

What's the word for that? Solipsism?


Buckaroo - I am not advocating BigCo as a specific example of how a company might save us, and yes, and 20% ROC will surely prompt its price to be bid up.

The BigCo was meant to (and apparently did not) illustrate the point that if you make a poor assumption about reinvestment, you get a misleading result.

I am not particularly interested in shredding Brad DeLong's response to the CEA in more detail than I already have, but it seems that you have not responded to my point - his embedded assumption is that US companies must (a) grow at a low rate tracking the US economy; (b) pay dividends at a low rate, and therefore (c) have a low return on capital.

IF companies simply raise their payout rate (and the dividend yield, like the Constitution, is not a suicide pact), then the mathematical impossibility is solved - capital *and* profits grow at the low rate, but the total return (Capital growth +dividends) is 6.5%.

Or, Brad DeLong left out chocie (d) - companies can invest their "excess" cash abroad.

E.g., my capital base is 100, and GDP is 10,000, slated to grow by 1.5%. I have a 6.5% ROC, which means I earn $6.5; I pay out $2, grow my capital in the US by 1.5%, or $1.5, and invest the balance (3%, or $3) abroad.

Next year, my capital is stil 1% of GDP; my *US* profit is still 6.5% of *US capital*, or (1% x .065) of *US GDP*; My US profit has grown by 1.5%.

However, I now have $3 of foreign capital, on which I also earn a 6.5% return, so my *total profits*, US + Foreign, manages to grow by 4.5%;

I pay out 2% based on my new capital (Foreign + US, I suppose), reinvest enough in the US to grow my US capital by 1.5%, reinvest the balance abroad, and carry on.

Or, I suppose I could pay 2% only on my US capital; in that case, my Dividend/Total Capital ratio will fall over time.

What will happen? Well, what *won't* happen is, my US profits will not grow to an absurd share of US GDP. IN fact, they will remain at ther same starting percentage, because my US capital will always be 1% of US GDP.

However, my foreign capital will grow quite quickly (in the early years, the additional reinvestment is quite large relative to the starting value (O, in my assumption, but that is arbitrary.)

And at some point way down the road, foreign earnings could overtake US earnings. So what - has anyone looked at a P/L for Daimler/Chrhysler, or Nokia, or Royal Dutch Shell?

As long as the world economy grows at, off hand, 4.5%, my share of the world economy won't lead to an impossible outcome - after an early "catch-up" period, the very long run equilibrium (assuming World growth = 4.5%, US growth = 1.5% forever) will have most of my capital and profits coming from abroad; since my capital base is growing at 4.5% (6.5% less 2% dividends), I don't grow faster than the world, and all is well.

I would love some feedback, because this point seems to me to be (a) crystal clear, and (b) widely misunderstood. And I do thank Spencer and, I guess Brad DeLong, for their helpful examples.

Not that I won't to pick on him behind his back, but that is now two people offering me the DeLong post as a rebuttal. Troubling.

I hope to zip out a peppy new post arm-wrestling all this. Your thoughts will be welcome, of course. (And if I am stone wrong about this, you guys *really* let me down. But no worries.)


Tom, the consistent argument here is either d) or a variant of d) in which US investors create their own international diversification by reinvesting their dividends overseas. It would make things clearer if you dropped all this confusing stuff about the payout ratio, since you appear to have accepted the point that the dividend yield has to be reinvested *somewhere* in order to provide a compound return. Because any reinvestment of the dividend yield in the USA would produce GDP growth, you need to find a way to reinvest the cash flow which doesn't create production in the USA, hence the "foreign earnings" argument.

The foreign earnings argument is mathematically consistent, and I do think that Brad and Paul Krugman ought to take it more seriously. But, veecea versa, you (and Jim and Patrick) need to be more explicit about what you're actually forecasting.

1. This has to be a *net* flow of capital out of the USA. Just as the overseas reinvestment of US companies grows capital income without affecting GDP, any foreign investment in the USA in this model increases GDP without changing US capital earnings.

2. Therefore, it is a model under which the USA has a structural and large current account surplus, and the method by which this surplus is to be achieved might be made clearer.

3. Related to this, foreign capital assets need to be paid for with foreign currency rather than dollars. This might be how the surplus was achieved; the massive net overseas investment of US corporations would mean equally massive net selling of dollars, pushing the exchange rate down. But it is no more explicit in your model that you are forecasting a foreign exchange crash than it is in the CEA model that they are forecasting a stock market crash.

4. Following on from the devaluation argument, it also appears to me to be a "beggar-thy-neighbour" policy. The eurozone, the UK and Japan also have retirement savings problems, and your equivalent in those countries is also presumably suggesting a model under which they run massive current a/c surpluses and have a devaluation. It is not possible for all of these investment aims to be achieved unless ...

5. Unless you believe what seem to me to be implausible things about China, Brazil and Russia. For the reasons outlined above, when we're talking about "foreign earnings" here, it more or less has to be emerging markets (I would love to believe that you're basing your projections on the assumption that France and Germany will grow much faster than the USA over the next forty years, but I'm guessing not so much). So we're assuming;

6. That the growth path of these economies will be consistent with the reinvestment ambitions of developed world corporations - this is possible, but no reason to believe that it would be.

7. That the return on capital in these economies is the same as or higher than in the USA - decent theoretical reason to believe this (capital scarcity) but the empirical evidence is all the other way.

8. That the financial development of these countries will also be consistent with the reinvestment needs of developed countries; at present, there is simply no way that you could invest 3% of US payrolls in emerging markets because there just aren't enough securities to go round.

9. That these countries will maintain the favourable demographics which make it plausible to believe that foreign savings will supply the majority of their capital base; given the one-child policy in China, I would suspect that on a forty year view this one might be vulnerable.

10. That there will be no political implications arising from the fact that by 2030 the bulk of the developing world's capital stock will be owned by foreigners. The Royal Navy in its imperial period spent a fair old chunk of gunboat/hours chasing round the world looking after the interests of its investors and it was not what you'd call an unqualified success.

and finally

11. That the idea of saving Social Security by placing the retirement incomes of US pensioners into banana republics passes the laugh test, which I would contend it does not.

Sorry; that was far more than "Just One Minute", but I warmed to my theme. I'll probably repost this on my own weblog, which some might suggest I should have done in the first place. Best, dd.


As long as the world economy grows at, off hand, 4.5%

Remember that it's the investable world economy that needs to grow at 4.5% for this to work. Clean water and AIDS prevention would do wonders for the GDP of a lot of African countries, but not necessarily in a way that would generate capital income for US citizens. The growth of "the world economy" has a quite heavy weighting of China and India in it, and the assumption that these markets are investable without limit does not look safe to me.

Patrick R. Sullivan

"eventually, Dems will hit on ideas that make sense"

You've finally offered a bet I'm willing to take.

dsquared, it's touching that you remember...and just in time for Valentine's Day!

However, I can't help but notice a certain...er...White Man's Burden quality to your argument.


Well I can't help but notice a certain "Girls Gone Wild" quality to yours. What on earth do you mean?


Elsewhere, guys.

Now, as to the foreign exchange/foreign investment issue:

(1) The basic problem seems to be that we have excess cash piling up and producing odd results - the economy grows at 2%, my profits grow at 4%, doesn't that mean my capital base grows at 4%, and doesn't that mean that both capital and profits become too large for the US?

(2) Compounding gets addressed at the new post (sorry), "Does Your Model Have HAIR". The key point is that compounding is exactly what we do not want.

(3) *IF* the foreign investment seems to be too large, increase dividends. The Baker-Krugman formulation limits the allocation of profits to either dividends, or US (re)investment. By relaxing that, allowing higher dividends, and foreign investment, the paradoxical US result disappear. But if paradoxical foreign results seem to be a problem, just raise the dividend rate.

Now, could there be some grand equilibrium where (a) companies can't find any worthwhile investments at 6.5%, so; (b) they increase dividends; (c) investors don't want the money, so they re-invest it in shares; (d) companies, flush with cash, pursue projects with a 5% return.

Possible? Sure. A mathematical inevitability? Why? And wouldn't that be tied to some broader forecast about global equity returns? And over the next few decades, aren't all these oldsters supposed to be living off of dividends and interest, as consumers rather than savers?

As to this:

1. This has to be a *net* flow of capital out of the USA. Just as the overseas reinvestment of US companies grows capital income without affecting GDP, any foreign investment in the USA in this model increases GDP without changing US capital earnings.

2. Therefore, it is a model under which the USA has a structural and large current account surplus, and the method by which this surplus is to be achieved might be made clearer.

If the corporate sector is collectively generating excess cash (I.e., profits less dividends less new US investment), why can't they invest overseas?

I know there is an accounting identity lurking here, but I am trapped without pencil, paper, or coffee.

OK, here we go (these are annual flows): US Invest Overseas = Foreign Invest Here + US Exports - US Imports

So, imagine year 1 - $0 foreign investment = $500 Foreign invest here + $100 Exports less $600 imports.

This is roughly the current situation - we have a big trade defitcit financed by foreigners. Recently, in fact, it has been foreign central banks buying T-bills, which may be important in response to "(1) This has to be a *net* flow of capital".

So, I increase my foreign investment by $50 in year 2. To balance the other side, maybe foreign central banks buy more T-bills. Or maybe we reduce our trade deficit. Or both.

Put another way - Japan runs a trade surplus and invests abroad; I am saying the US will run a trade deficit and invest abroad. Huh?

Ahh, no worries - we reduce our trade deficit over time, and increase our foreign investment. Foreign central banks roll over their financial assets, but the outstanding balance doesn't change.

And slowly the US reduces the trade deficit, and becomes a net exporter - if we grow slowly, and the world grows quickly, isn't that what happens? (I don't see why, actually - is West Virginia a net exporter to California, since CA has grown so much faster?)

Or, if all of our old folks "need the money", the issue never develops - companies pay out their cash as dividends, rather than invest overseas.

As to the other aging countries, presumably we will all (a) export capital to the developing world, or (b) save less, consume more. (b) looks OK to me.


Tom, the dividend payout is a red herring. The 6.5% return assumed in the projections is a compound rate of return. It therefore implicitly assumes dividends are reinvested.

Think about it this way. If we pretend for the while that there are no international cashflows (for the moment; I just want to get this dividends thing nailed), then the payment of $xmn in retirement income in 2042 has to come out of the GDP of 2042. In order that this $xmn is there in 2042, the economy has to have reached a certain size. In order to reach that certain size, given a rate of return on capital, a certain amount of production has to be invested. If all the production of the country goes into wages and (consumed) dividends, then this will not happen. (If companies adopted 100% payout ratio and there was no investment for the next 40 years, then the return on capital would still be 6.5%, but the 2042 economy would be the same size as the 2005 economy and there would not be enough money to pay retirement incomes).

So at some level in your model, there has to be investment and growth. And that investment and growth will show up in GDP. It's an accounting identity. If you focus on the underlying process of production it's clear; we need to channel 2042 production into old people. We can either do it through investments and call it dividends and capital gains, or do it through the tax system. But any set of assumptions about underlying production which solve the problem in one case, solve it in the other.


Let's get real. This has nothing to do with economic growth numbers. This whole (partial) privatization of Social Security is about trust. Krugman et al believe that the government could never renege on the promise of Social Security, while Bush et al know damn well that it will be scaled back at some point (pick your own date).

Meanwhile John Q. Public will only hear that the promise is gone. As the date for empty coffers draws near, the political emanations will be ripe for the plucking, the public nearing retirement will storm the Bastille .. er .. D.C.

Right about then, that (partial) private Social Security account will sound pretty damn good, don't you think ?


Just to be real simple about it, the US must either grow through productivity, or cut costs, in order to boost profits in a relentless average upward trend as it has been doing for decades.
It is likely to be forced to cut costs at some point, simply to compete. And this is likely to be resisted, as well as demands to occur for competitor nations to bring up standards (thus costs) for their workers.
This will create a awful political tension, which we are just experiencing the beginning of now.
It does seem unjustified to expect it will be smooth sailing to relentlessly cut costs here, and to not even mention that as an assumption in Soc Sec forecasting.
It's a big assumption, and posits a future very different than our past as a nation.
Even when Bush says 'ownership society' to sum it up, and people envision more stocks owned more widely, he doesn't bundle this up with the idea of falling real wages, benefits and labor freedoms.
It's not really a fair, authentic sales pitch.
You need to be willing to present the total package of what a person's work life and retirement life would look like in trying to sell these dramatic Soc Sec changes and assumptions, and do so in really plain and simple non-techie english for consumption by the general public.
I doubt they will buy it.
But I agree tension around these future directions can only increase.

The comments to this entry are closed.