Friday, March 25, 2005

Krugman & DeLong versus Krugman & DeLong on productivity and Social Security's future.

I. Lower productivity growth in the future will contribute to a decline in stock returns compared to the past (so private equity investments in Social Security are a bad idea).
Dean Baker, J. Bradford DeLong, and Paul Krugman (forthcoming 2005), "Asset Returns and Economic Growth," Brookings Papers on Economic Activity 2005:1.


We in America are probably facing a demographic transition—a slowdown in the rate of natural population increase — and possibly facing a slowdown in productivity growth as well. [emphasis added]

If these two factors do in fact push down the rate of economic growth in the future, is it still prudent to assume that the past performance of assets is an indication of future results? We argue "no"... [SDJ-1]
II. Higher productivity growth in the future hasn't yet been recognized in the Social Security actuaries' projections, so their estimate of Social Security's future deficits is exaggerated (and exaggerates the need to do anything about them now).

One would think that the fact that productivity growth has averaged 3.0% per year in the four years since 2000 would be worth a mention. One would expect some reason for completely throwing away the last four years' worth of data on productivity.

But it isn't there ... we've had good productivity news in the past four years: the Trustees' Report should recognize it.

UPDATE: Paul Krugman comments:
[...] high productivity growth since 2000... seems like big news... [but] isn't factored in at all. The reason is that the trustees use an average over the past four "full business cycles," measured from peak to peak (Section IV.B.7).... [T]hey won't take the good productivity news since 2000 into account [at all in forecasting the future] until the economy [begins] another recession. There's something very wrong with that...

So now we can all see just how badly the Social Security actuaries have messed things up. They've not taken into account either how the coming slowdown in productivity growth will reduce stock returns to below their 6.5% estimate, or how future sustained high productivity growth will reduce the funding gap to below their estimate. Fire those guys!


By the way, here's a query for the Baker/Krugman/DeLong axis of reduced asset return and its allies.

Will the reduction in return on assets affect bonds as well as stocks? And if so, what does this mean for the discounted to current value size of Social Security's future funding gap -- which is discounted by the bond rate?

That is, today the Social Security actuaries use a 3% real bond rate to discount the future funding gap to a current value amount of $4 trillion through 2079.

But the actual 1946-to-2004 average annualized real return on Treasury bonds was only 1.6% (with the very high returns of the historic 1981-2004 bull bond market, which is extremely unlikely to be repeated from here, needed to achieve even that) and many authorities say 3% is much too high, as noted here previously.

And now we also have the "lower future return to assets" argument too! So let's say the critics of a 3% projected bond rate are indeed right.

Let's say the future return on bonds that we should realistically expect over the coming 75 years is actually 1.5% or less -- less than the historic rate, as per the axis' argument-- instead of the actuaries' 3%. What happens to the current value of the funding gap?

Well, a dollar of deficit to be incurred 75 years from now when discounted at 1.5% is about three times larger in current value than one discounted at 3%.

Are we looking at a 75-year funding gap that when properly discounted is closer to $8 trillion than $4 trillion?

But wait ... that original $4 trillion is just the funding deficit facing the Social Security Administration, which naively assumes some sort of "free money" will become available to make up for the lack of any savings in the trust fund, and so doesn't count the cost of trust fund operations post-2018 2017.

Of course the true funding gap for Social Security is that facing the government. That gap -- including the cost of redeeming the bonds in the trust fund -- was over $5.2 trillion last year according to the Treasury [.pdf], and is now about $5.5 trillion, again discounted at a 3% real bond rate.

But if the "reduced return to assets" argument is right and includes bonds, so future bond returns will be under 1.5%, are we looking at 75-year funding gap that when properly discounted is really closer to $11 trillion? And an open-ended gap that is a lot larger than that?

Hello? Fellows??