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...modern feminist revolution two generations old: no reservoir of potential female labor remains to be added to the paid labor force. Immigration will doubtless continue--the United States is likely still to have only one-twentieth of the world's population late in this century and to remain vastly richer than the world on average--but can immigration proceed rapidly enough to make the labor force grow as fast in the next fifty years as it did in the past fifty? Productivity growth, the other possible source of faster GDP growth, is a wild card: although we find very attractive the arguments of Robert Gordon for rapid future productivity growth, (1) his is not the consensus view; this is shown most strikingly by the pessimistic projection of the Social Security trustees that very long run labor productivity growth will average 1.6 percent a year. (2)
A slowing of the rate of real economic growth raises challenges for the financing of pay-as-you-go social insurance systems that rely on a rapidly expanding economy to provide generous benefits for the elderly at relatively low tax rates on the young. An alternative way of financing such systems is to prefund them, and for that reason projections of future rates of return on capital play an important role in today's economic policy debates. The solutions to many policy issues depend heavily on whether historical real rates of return--especially the 6.5 percent or so annual average realized rate of return on equities--are likely to persist: the higher are likely future rates of return, the more attractive become policies that, at the margin, shift some additional portion of the burden of financing social insurance onto the present and the near future, thus giving workers' contributions the power to compound over time.
We believe that the argument for prefunding--that slowing economic growth creates a presumption that the burden of financing social insurance should be shifted back in time toward the present--is much shakier than many economists recognize. (3) It is our belief that if forecasts of slower real GDP growth come to pass, then it is highly likely that future real returns to capital will likewise be significantly below past historical averages. In our view the links between asset returns and economic growth are strong: the algebra of capital accumulation and the production function and the standard macrobehavioral analytical models that economists use as their finger exercises suggest this; arithmetic suggests this as well, for we cannot see any easy way to reconcile current real bond, stock dividend, and stock earnings yields with the twin assumptions that asset markets are making rational forecasts and that rationally expected real rates of return will be as high in the future as they have been in the past half-century.
Our basic argument is very simple. Consider a simple chart of the supply and demand for capital in generational perspective (figure 1). The supply of capital--the amount of investable assets accumulated by savers--presumably follows a standard (if probably steeply sloped) supply curve, (4) with relative quantities of total saving and thus of capital plotted on the horizontal axis, and the price of capital--that is, its rate of return--on the vertical axis. The demand for capital by businesses will, of course, depend on the rate of return demanded by the savers who commit their capital to businesses: the higher this required rate of return, the lower will be business demand for capital--and the more eager will businesses be to substitute labor for capital in production. The demand for capital by businesses depends on many other factors as well, from which we single out two:
[FIGURE 1 OMITTED]
--The rate of growth of the labor force. Labor and capital are complements. A larger labor force for firms to hire from will raise the marginal product of capital for any given level of the capital stock, making businesses more willing to pay higher returns in order to get hold of capital.
--The rate of improvement in the economy's level of technology. Better technology--also a complement to capital--will boost business demand.
What is the effect of a slowdown in economic growth--through either a fall in the rate at which the labor force grows, or a fall in the rate at which technology and thus equilibrium labor productivity increase--on this equilibrium? Assume that these changes do not affect the saving behavior of the accumulating generation: (5) then they affect only the demand curve and not the supply curve. Each of these shocks moves the demand curve leftward: having fewer workers reduces the marginal product of capital and hence firm demand for capital; slower productivity growth does the same. The equilibrium capital stock falls, and the rate of return that savers can demand, while still finding businesses willing to invest what they have saved, falls as well. Slower economic growth brings with it lower real rates of return.
We make our case as follows. After first laying out what we see as the major issues to be resolved, we discuss how the algebra of the production function and capital accumulation suggests that rates of return and rates of growth are strongly linked. We then analyze the standard, very simple, macrobehavioral models that economists use to address these issues and find that they, too, lead us to not be surprised by a strong positive relationship between economic growth and asset returns. We then turn to the arithmetic: starting from current bond, stock dividend, and stock earnings yields, we find it arithmetically very difficult to construct scenarios in which asset returns remain at their historic average values when real GDP growth is markedly slowed.
Next we turn to what we regard as the most interesting possibility for escape from this bind. In the late nineteenth century, slower growth in the British economy was accompanied by no reduction in returns on British assets, as Britain exported capital on a scale relative to the size of its economy never seen before or since. Could the United States follow the same trajectory? Yes. Is it likely to? Not without a huge boost to national saving.
Before concluding, we turn to a brief analysis of the equity premium. Much argument and some analysis of the dilemmas of the U.S. social insurance system point to the large historical value of the equity premium in America as a potential source of excess returns. We argue, however, that once one has conditioned on the level of the capital-output ratio, returns on balanced portfolios in the long run depend only on the physical return to capital and the margins charged by financial intermediaries. (However, attitudes toward risk do affect the long-run capital-output ratio.) They do not depend on the equity premium or the price of risk.
We conclude that if economic growth over the next century falls as far as envisioned by forecasts like those in the 2005 Social Security trustees' report, then it is not very likely that asset returns will match historical experience. If the stock market today is significantly overvalued and about to come back to earth, if the distribution of income undergoes a significant shift away from labor and toward capital, or if the United States massively boosts its national saving rate and runs surpluses on the relative scale of pre-World War I Britain, for more than twice as long as Britain did--then a real GDP growth slowdown need not entail a significant reduction in asset returns. But these seem to us to be possible, not probable, scenarios, and not the central tendency of the distribution of possible futures that is a real economic forecast.
Issues
The United States is in all likelihood undergoing a minor demographic transition: from a twentieth century in which the population's rate of natural increase was high, to a twenty-first century in which, many suspect, fertility will be at or below levels consistent with zero population growth. This will translate into a slowdown in growth in labor input. From 1958 to 2004, total hours worked in the economy grew at 1.5 percent a year as the entrance of the baby-boomers--male and female--and their successors into the labor force vastly outweighed a decline in average hours worked. The Social Security Administration's 2005 trustees' report projects that hours worked will grow at only 0.3 percent a year from 2015 through 2045. (6)
Meanwhile some economists--although far from all--are projecting a slowdown in productivity growth] The Social Security Administration foresees economy-wide labor productivity growing at only 1.6 percent a year in 2011 and thereafter. In contrast, between 1995 and 2004 economy-wide labor productivity grew at 2.5 percent a year, between 1990 and 2004 it grew at 2.0 percent a year, and between 1958 and 2004 at 1.9 percent a year. (8) Thus, less than a decade from now, the Social Security forecasters at least see a significant change in both key factors in economic growth: a fall of 1.2 percentage points a year in the rate of growth of labor input, and a fall of between 0.3 and 0.9 percentage point, depending on whether one takes the long 1958-2004 or the short 1995-2004 baseline, in labor productivity growth. The total growth slowdown forecast to hit in a decade or less is thus in the range of 1.6 to 2.2 annual percentage points of real GDP.
What implications will this growth slowdown--if it comes to pass--have for asset values and returns? One position, taken implicitly by the Social Security Administration and explicitly by others, (9) is that there is no reason to expect asset returns to be lower in the future. Whereas U.S. economic growth is determined by productivity growth and labor force growth in the United States, U.S. asset returns are determined by time preference, the intertemporal elasticity of substitution in consumption, and attitudes toward risk, all in a global economy. Why should they be connected? Thus, we hear, past asset performance is still the best guide to future returns.
We take a contrary position. Yes, safe asset returns are equal to the marginal utility of saving, stock market returns equal safe asset returns plus the cost of bearing equity risk, and the United States is part of a world economy. Yes, economic growth is equal to productivity growth plus labor force growth. But only in the case of a small open economy with fixed exchange rates are asset returns determined independently of the rate of economic growth. In a large open economy, they are jointly determined and will be linked. (10)
Perhaps an analogy will be helpful. In international trade, the trade balance is the difference between what exporters are able to sell abroad and home demand for imports. In international finance, the trade balance is the difference between national saving and national investment. How can this be? Why should a change in exporters' success at marketing abroad change either national saving or national investment? Great confusion has been caused throughout international economics over how, exactly, to think of the connection. We believe that claims that national economic growth is unconnected with asset returns reflect a similar failure to grasp the whole problem.
This is an important issue to get straight now, because the relative attractiveness of pay-as-you-go versus prefunded social insurance systems depends to some degree on the gap between the return on capital r and the rate of real economic growth n + g, the sum of the rate of growth of employment n and the rate of growth of labor productivity g. If we are willing to be simple Benthamites, with a social welfare function that shamelessly makes interpersonal comparisons of utility, the argument is straightforward. The higher is the rate of economic growth n + g relative to the return on capital r, the more attractive do pay-as-you-go social insurance systems become. When n + g approaches r, pay-as-you-go systems appear to be very cheap and effective ways of increasing social welfare by passing resources down from the rich and numerous future to the poorer and less numerous present. By contrast, the larger is r relative to n + g, the greater are the benefits of prefunding social insurance systems. Prefunded systems can use high rates of return and compound interest to reduce the wedge between productivity and after-contribution real wages. They thus sacrifice the possibility of raising social welfare by moving wealth from the richer distant future to the near future and the present, but in return they gain by reducing the social insurance tax rate and thus its deadweight loss. And whenever we make utilitarian arguments other than those of pure Pareto-preference for why one set of policies is superior to another set, we are all, in our hearts, secret Benthamites.
Thus, to the extent that the political debate over the future of social insurance in America is conducted in the language of rational policy analysis, getting the gap between r on the one hand and n + g on the other hand right is important. Policies predicated on a false belief that r is much larger relative to n + g than it is will unduly burden today's and tomorrow's young people and will leave many disappointed when returns on assets turn out to be less than anticipated and prefunding leaves large unexpected holes in retirement financing. Policies predicated on the belief that n + g is higher relative to r than it is pass up opportunities to lighten the overall tax burden and still...
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