Unexpectedly Intriguing!
February 27, 2005
Update: Welcome Carnival of the Capitalists readers!

Ever since economist John Kenneth Galbraith coined the term "conventional wisdom" in his book The Affluent Society, a lot of the public's collective wisdom has been directed toward how changes in the status quo will affect the future of the U.S. economy. One of the newly held common beliefs is that the U.S. stock market will take off like a rocket should the option to add a Personal Retirement Account (PRA) option to Social Security's retirement benefit program be adopted.

The thinking goes something like this:

  1. There's a relatively fixed supply of stocks.
  2. Money invested through PRAs will increase the demand for these stocks.
  3. Since the demand for stocks will increase, and the supply of stocks will remain roughly the same, stock prices (and the stock market) will go up.

Makes perfect sense, right? It's the Law of Supply and Demand. It has even been suggested that you can train a parrot to be an economist by teaching them to repeat the phrase! But is it really that simple when it comes to Social Security reform and the stock market? Let's look at both the Supply and the Demand sides of the equation.

The Supply of Stocks

Unlike the public's perception that the stock market is a pretty static place, in reality, the stock market is a *very* dynamic environment. Every day, a new supply of stock is issued by both new and existing publicly traded companies, while other stocks previously issued into the market are removed through various processes of buy-backs, mergers and acquisitions, bankruptcies, and so on. The supply of stocks in the stock market constantly grows or shrinks over the net exchange. Over the long term, the market is efficient at matching the available supply of stock to the demand for it. In the short term however, it would be logical to expect a bump up in stock prices, which would last for as long as it takes the market to adapt by drawing more companies into the market to compete for this increased supply of capital.

The Demand for Stocks

The demand for stocks is the trickier of the two sides of the equation to take into account. While the PRA option would allow people who otherwise would not be able to own shares of publicly traded companies to do so, when it comes to measuring what the change in demand for stocks will be, the real question comes down to what will the people who already regularly invest in stocks through their 401(k) plan, 403(b) plan, Individual Retirement Accounts or on their own do?

The answer hinges on the "whys" of the reasons individuals invest for their retirement through the stock market. For older people eligible for the proposed Personal Retirement Account option, their PRA contributions will likely represent a means of supplementing income from their other retirement plans. I suspect that those who fit this description and who select the PRA option will likely provide much of the increased short term demand for stocks, but their influence on the overall level of the market will be limited due to the proposed introductory cap on contributions (see this 45K PDF document) that will hold down the amount of capital coming into the market in the program's early years.

For younger people already investing in stocks through their retirement plans, there is another conventional wisdom, backed up by projections from the Social Security administration, that the retirement benefits that will come to them from the current program will be sharply reduced compared to those received by older generations. They are investing toward their retirement now to make up for the expected future shortfall.

Here, I believe the key issue of the future will involve trust. Once the PRA option is established, and its performance able to be assessed from real-life data, the younger generations participating in the program may choose to reduce their contributions to their other retirement plans since they will be able to reasonably determine if they will be able to rely on the returns from their PRA. If they assess that they can rely on their PRA returns, they will likely redirect some of their current level of retirement-focused investing into other areas, allowing them the advantage of being able pursue other opportunities with their earnings, which would mean that value of the stock market is unlikely to be directly affected in the long term from the proposed reform.

Final Thoughts and Questions

It remains to be seen if there will be an option for individuals to apply a portion of their Social Security taxes toward Personal Retirement Accounts. My thinking is that should the PRA option become available, it will only have a direct effect upon the stock market in the short term, and not in the long term. The question then becomes will it have an indirect effect? What will happen if the PRA option becomes trusted enough to allow younger generations to have the confidence to redirect their other earnings away from investing to support their future retirement? Will their redirected earnings provide the basis for greater economic growth that will in turn support greater growth in the value of the stock market? Only time will tell.

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