May 17, 2000
RECKONINGS / By PAUL KRUGMAN
Unhappy Returns?
T he debate over Social Security reform is not exactly noted for
witty repartee. But one much-repeated joke says that the pace of
reform will determine the future of stock prices: the big crash
will come only once a few trillion dollars of the retirement fund
have been put into the market.
Gallows humor aside, it's a real issue. Historically, investors who
bought stocks have earned much higher returns than the Social
Security Administration, which buys only government bonds.
Inevitably, then, many would-be saviors of Social Security believe
that stocks are the answer to the system's problems. But if you use
conventional ideas about valuation, today's stock prices look very
high. So would investing in stocks now be a classic case of bad
timing?
This question has suddenly become much more relevant, now that
George W. Bush has announced his Social Security plan. He doesn't
want the trust fund itself to buy stocks. But he does want to let
workers put some of their contributions into individual retirement
accounts, which could be invested in stocks. And he justifies this
proposal by pointing to the high returns that stock market
investors have historically earned, and comparing these returns
with the "dismal" returns of the Social Security Administration.
The higher returns people can get by investing in stocks will, he
argues, let him scale back guaranteed benefits without reducing
actual retirement income.
If you think that stocks are currently overpriced, this proposal
sounds like a recipe for disaster: it will encourage workers to buy
stocks at exactly the wrong time -- eventually leading to an even
worse Social Security crisis, as the government finds itself under
intense pressure to bail out the baby boomers.
But optimists counter that even though stocks look overpriced by
conventional measures -- the price-earnings ratio of the average
S.&P. 500 stock is more than twice as high as the historical
average -- those conventional measures are misleading. The sensible
argument on behalf of current stock valuations is that historically
stocks have been underpriced, because investors have been far too
cautious.
Economists who make this argument point to the same statistics
cited by Mr. Bush: the fact that stocks have consistently yielded a
much higher rate of return than bonds. Why this "equity premium"
persisted so long remains a puzzle: why didn't investors long ago
rush into stocks, driving their prices up and their rate of return
down? But anyway, the puzzle is now history: in the 1990's
investors did rush into stocks. What the optimists believe is that
this rush corrected an error rather than creating one, that the
rise of the stock market in recent years reflects not the rise of
irrational exuberance but the decline of irrational risk aversion.
I have my doubts about this story. But suppose that it is right,
and that current stock valuations are in fact reasonable. Does this
then validate Mr. Bush's plan? Alas, no. You see, those high
returns cited by Mr. Bush -- the returns that are supposed to
produce huge gains for workers free to make their own investment
decisions -- are what stock investors got during an era in which
people were very leery of stocks, and hence prices were low
compared with earnings. Now that people are no longer so nervous,
prices are much higher compared with earnings -- and the higher the
price you pay for an asset, the lower the rate of return on your
investment. (Duh.) So the rate of return on stock investments made
now will probably be much lower than the returns people got in the
past. (Remember, this is the optimistic scenario, which claims that
current values are reasonable -- if they aren't, the return will be
even lower.) And that means that the proposition that individual
investors can expect to do a lot better than the Social Security
Administration -- so much better that we can wave away concerns
about increased risk -- evaporates.
So Mr. Bush can defend himself against the charge of bad timing by
arguing that stocks are not overvalued, that their high prices are
justified because people no longer demand traditionally high rates
of return. But how can he then assume that people will nonetheless
get those traditional high returns -- and use that assumption as
the basis for a huge policy initiative?
I just don't get it. But then, I'm not running for president.
Copyright 2000 The New York Times Company