With the President having recently refined his proposal for reforming Social Security, the second generation of web-based calculators that purport to model the President's proposal are just now coming online. While I have not yet finished detailed reviews of the Version 2.0 efforts, I have seen enough of the "Accurate Benefits Calculator" developed by the Washington D.C. based Center for Economic Policy Research to conclude that it's a wasted effort whose primary purpose is to misdirect its users into accepting its unfounded underlying assumptions.

Which is a shame, because it otherwise has a relatively clean interface, some really neat features (the graphing function is truly cool), and it does its math correctly. If it were not fundamentally flawed in its methodology, it would be a real contender for Political Calculations' Gold Standard. But it is, and it no more deserves the award than the highly flawed first generation effort put forward by the Senate Democrats.

The key element of CEPR's effort at misdirection revolves around the calculator's assumption that the rate of return in the stock market may be directly related to the rate of growth in the United States' Gross Domestic Product (GDP). This assumption is detailed in CEPR's accompanying methodology (available as a 23KB PDF document), which shows the derivation of a mathematical formula linking growth in GDP to the stock market returns. The formula, when fully derived, links the stock market's rate of return to it's Price-to-Earnings (P/E) ratio, it's Dividends-to-Earnings (D/E) ratio and the rate of growth in GDP (G). I'll account for the math, as it's nearly perfect - if I were grading it, it would receive 9 out of 10 points (not all work was shown, but it was possible to figure out the missing steps). A much larger version of the miniaturized image at the right detailing CEPR's math is available.

By linking growth in GDP to the rate of return one may expect from the stock market, the effect of CEPR's assumption is to reduce the stock market rate of return well below its long term inflation-adjusted average of 6.5 to 7.0% given what would otherwise be reasonable P/E and D/E ratios. The value identified as being a "stable" rate of return from equities by CEPR is 4.35%, more than 2.0% too low when compared to the stock market's long term averages. Users of the CEPR calculator are warned against increasing the "premium" on stock market returns, since this action may produce P/E and D/E ratios that represent "implausible levels." It would take a very knowledgable user to recognize that the "implausible levels" in the Price to Earnings ratio and the Dividends to Earnings ratio are the result of an assumption that is, in itself, utterly unrealistic.

Correlating GDP Growth and the Stock Market

When I say there's a mountain of data to test the assumption, I mean it. Perhaps the most comprehensive example of this data is represented in the most recent release of the Global Investment Returns Yearbook, which provides a comprehensive analysis of the long-term record of investment options (including stocks, bonds, etc.) around the world since 1900. The yearbook is the result of the work of the London Business School's Professors of Finance Elroy Dimson and Paul Marsh, and the school's Director of the London Share Price Database Mike Staunton. The Ireland-based business and personal finance portal finfacts.com notes:

The core of the Yearbook is provided by a long-run study covering 105 years of investment since 1900 in all the main asset categories in Australia, Belgium, Canada, Denmark, France, Germany, Ireland, Italy, Japan, the Netherlands, Norway, South Africa, Spain, Sweden, Switzerland, the United Kingdom, and the United States. These markets today make up over 92% of world equity market capitalisation. With the unrivalled quality and breadth of its database, the Yearbook has established itself as the global authority on long-run stock, bond, bill and foreign exchange performance.

The authors of the Yearbook examine all this data, considering whether or not there is a real correlation between the growth in a nation's Gross Domestic Product (GDP) and the real rates of return provided by their stock markets. They find that:

• Using data for all 17 countries, including that for the rapid post-war expansion period in the German and Japanese economies, the authors demonstrate that there is no apparent relationship between equity returns and GDP growth.
• The study also analyses additional countries where data is available, but for fewer than 105 years. Using this extended group of 53 countries, the authors again find no relationship between economic growth and stock returns.

- Excerpted from finfacts.com

The following chart illustrates the inflation adjusted rates of GDP growth per capita and the rates of return in the stock markets of the seventeen countries with data extending back to 1900:

Click for a larger image.
Source: ABN AMRO/LBS Global Investment Returns Yearbook 2005 (Chart 28), via finfacts.com.

The lack of consistent proportionality between each country's rate of GDP growth and the rate of return in its stock market across the board shown in the chart illustrates the lack of correlation between the two figures. For reference, the data from the chart is presented in the dynamic table below. Click any of the column headings to rank the countries according to their respective performance:

A Sad Conclusion

The problem with the assumption advanced by CEPR, which I should note has also been advanced by economist Paul Krugman, is that it does not agree with historic data. At all. If the assumption that the nominal return on stocks is tied to nominal growth in the economy is going to be considered to be valid, it has to be able to demonstrate that the correlation exists in the mountain of data available to test the hypothesis. This is the test the CEPR calculator fails. Worse, it demonstrates a lack of critical thinking and understanding of scientific method on the part of those who developed and advanced this key assumption behind the calculator's math. At the very worst, it suggests either that those advancing the assumption do not understand basic economic principles or are all too willing to resort to dishonesty for the sake of making a partisan argument.

Sadly, much of the calculator's user interface is devoted to convincing its users to not adjust the rate of return from the stock market to a more realistic, higher figure. As such, the calculator becomes little else than an exercise in misdirection, whose results must default to a lack of trustworthiness as its assumed links between the stock market's price to earnings ratio, dividend to earnings ratio and GDP growth are wholly without merit. In the final measure, it's just not worth the disturbing the flow of otherwise happy electrons to download the CEPR's calculator onto your personal computer.

Labels: social security

- posted by Ironman at 9:41 AM | Permalink | Home |