Tuesday, February 08, 2005

How big will the US economy be relative to the rest of the world 75 years from now? Still a giant? Or merely what Sweden is to Europe today?

This sort of question can have interest in its own right for those of a certain speculative bent. But it particularly pops to mind now in light of Paul Krugman's claim in his recent column that stock returns must decline in the near future from their historical levels.

His reasoning: Corporate earnings grow only as fast as GDP, stock values only rise with earnings, and GDP growth in the US is projected to slow to only about 2% when the baby boomers start retiring (due to the slowdown in the growth of the number of working age people), therefore the rate of appreciation in stock values must slow correspondingly from its historic average. And total return from US stocks must drop from the historical 7% to about 5%. QED.

Well, that's all reasonable enough, except for the "must" part and his challenge for people out there to find some way that the historic rate of return on US stocks can be maintained for the next 75 years with only 2% domestic GDP growth. Absolute statements coupled with challenges to refute them draw responses in the Internet!

As to that, the obvious simple possibility quickly suggested (elsewhere as well as here) is that US firms may in the future earn more profits from abroad, where GDP growth will be faster, and thus increase their ratio of total profits to US GDP. After all, is the growth in the total earnings of Sweden's international corporations (Nokia, Ericsson, Saab...) limited to no more than the growth in Swedish GDP? Are stock returns available to investors in Missouri limited by the growth of Missouri's GDP?

But this suggestion tends to elicit disbelieving responses along the line of: "Look at how much larger the US economy is than any other. Where are all those extra profits supposed to come from? Mexico??"

Thus, it becomes an empirical matter. The "Mexico" quip relates to today, but the challenge is for 75 years. So the question is: over the next 75 years will the US economy decline in size relative to total world GDP sufficiently to expect a substantial increase in the percentage of the total profits of US firms that is earned abroad?

Of course, nobody knows for sure as 75-year projections have wide error margins. Over the next 75 years we might have World Wars III & IV and a comet hitting the earth. And anybody who has a crystal ball that reliably predicts such things is greedily hoarding the profit opportunities it provides by not telling.

But we can make quite plausible ballpark projections based on the state of the world today and the most credible economic projections from here.

OK. Checking with The Economist and CIA Fact Book we find current World GDP at purchasing power parity of $51.5 trillion. Of this US GDP is $11 trillion -- or 21% (numbers rounded for convenience, as there's no point in making 75-year estimates to multiple decimal places.)

It's stipulated that US GDP will grow 1.9% annually over the 75-years, as per the Social Security actuaries and Krugman. How fast will the GDP of the rest of the world grow?

To figure this we need to separate the rest of the world into two parts. One consists of the other economically developed but aging nations, which today are the US's major trading partners but are in the same demographic situation we are in, or worse. Count among these the western European nations of the European Union plus Japan and Canada. Their combined GDP: About $15.5 trillion.

Then the remaining nations comprise the rest of the world, with GDP of $25 trillion.

Now let's look into the future...

We've stipulated that US GDP growth will average 1.9% -- so after 75 years GDP grows to $45 trillion from today's $11 trillion. For the other developed but aging nations let's estimate the same low 1.9% growth rate for pretty much the same reasons -- after 75 years their GDP reaches $63.6 trillion from today's $15.5 trillion.

What growth rate shall we estimate for the rest of the world? Well, 4% seems entirely credible and perhaps even conservative, being that it is well within the range of experience (world GDP grew 5% last year) and quite modest compared to the growth rates recorded historically by Asian and other fast-developing nations, which will constitute most of the rest of the world we are talking about.

So let's use 4%. At that rate in 75 years the rest of the world's GDP reaches $474.5 trillion, up from $25 trillion today.

Thus, for 75 years from now we get a projection of Total World GDP of $582 trillion, of which US GDP is $45 trillion, or 7.7%

The US economy winds up about only one-third as large relative to the rest of the world as it is today. (China's GDP becomes 2.8 times as large as US GDP, while India's becomes 1.3 times as large, assuming the same 4% growth rate for them. And little Mexico grows up from having GDP about 8% as large as the US to about 40% as large.)

How much will the foreign earnings of US corporations rise as a proportion of their total earnings (currently 17%) as the economy of the rest of the word triples in size relative to that of the US?

You can estimate that for yourself.

But the simplest answer to the Krugman challenge is just to set the GDP growth rate that determines the rate of growth of US corporate earnings as the world GDP growth rate.

Do that and if world GDP grows at 4% over the next 75 years that's two extra points and there we are -- right back to the stock market's historic 7% return.

(If anyone wonders why this should be the case in the 21st century when it wasn't in the 20th, well, back then there were little things operating like Communism and socialism taking most of the world out of the market, a couple of World Wars, capital controls, Smoot-Hawley and so on ... but past record is not a reliable indicator of future performance.)

After all, economists have long observed that market conditions in different parts of the world tend to equalize when they come into contact. So investors in Stockholm today have the opportunity to invest their private social security accounts to earn pretty much the same returns as are available to investors with private social security accounts in London -- irresepective of how the trend lines of Swedish and British GDP growth may diverge.

Perhaps someday US owners of private social security accounts will be given the same opportunity as well.