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February 2, 2005

In arguing against President Bush's proposed Personal (or Private) Retirement Accounts (PRAs), New York Times' columnist Paul Krugman completely misses the point about why PRAs will be necessary for the majority of today's working population in the United States in his February 1, 2005 column Many Unhappy Returns (Free, but registration required.)

First, let's deal with the crux of Krugman's argument. He states that:

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 mine.)

Krugman continues arguing his position by looking at the rate of economic growth he believes will be necessary to support these post-inflation stock market returns:

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.

Krugman then brings up the stock market's collective price-to-earnings ratio (P/E Ratio), which is a measure of how much stocks cost for every dollar of profit that the companies behind the stocks generate. He correctly notes that, historically, the stock market's long-term P/E Ratio is 14 (meaning that stocks cost $14 for every $1 in profit they generate) and that the current stock market P/E ratio is 20. He then proceeds to wonder what P/E Ratio would be required to support a 6.5% rate of return in a PRA.

Perhaps learning from the last time he needed to do math (Krugman notes that there are "technical issues" involved, I'm guessing he means basic algebra), Krugman goes to the Center for Economic and Policy Research's Dean Baker, who found that:

"by 2050, the price-earnings ratio would have to rise to about 70. By 2060, it would have to be more than 100."

Given his assumptions, this would seem to be a good point - a sustained stock market P/E Ratio of 70 or 100 is unlikely. The problem though is that he ignores history, and his own data! Somehow, over the past 200 plus years, the stock market has averaged a post-inflation rate of return of 7.0%, and since 1926, has averaged a rate of return of 7.4%, despite the 3.4% average annual rate of economic growth that Krugman has already noted. We should also note that this rate of return was generated despite the stock market having a long-term P/E Ratio of 14!

At the very least, this outcome would suggest that there are more factors to take into account in projecting stock market returns than just the market's overall P/E Ratio. While the stock market's past performance does not guarantee its future rate of return, should the post-inflation long-term rate of economic growth slow to just 1.9%, going back to the data Krugman uses to support his position, it would seem logical that the stock market long-term rate of growth would also slow, but remain positive.

This is the crucial point Krugman misses. Inflation-adjusted average individual rates of return from Social Security will become negative as the program becomes cash flow negative, currently expected to happen in 2018, and the accumulated trust fund is depleted, currently expected to happen by 2042. No matter how you slice the long-term rate of return from the stock market, and the best and worst case returns you could reasonably expect, it will still outpace the long-term rate of return from an unchanged Social Security program!

Aside from Krugman's previous points and his track record as an economist, he does note at the end of his column that:

"any growth projection that would permit the stock returns the privatizers need to make their schemes work would put Social Security solidly in the black."

In essence, his point is that if economic growth is greater than projected, it will not be necessary to reform Social Security since this growth will be enough to sustain the program. Of course, he ignores that PRAs would be a far superior option for individuals with the same economic forecast.

P.S.Tom Maguire also takes on Krugman's straw man.

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