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Thursday, May 19, 2005

By Ralf Seiffe

OPINION - In a recent column, I reported on a debate the Cato Institute held to discuss Social Security reform. Among other topics, the debaters took positions supporting and opposing the notion of personal accounts as one strategy to head off the system’s coming default.

Dr. Dean Baker from the Center for Economic and Policy Research represented the establishment position. His posited that private accounts are not a solution because they cannot meet their investment objectives of providing retirement security.

He supports his position by noting that the Congressional Budget Office projects a 1.9% rise in corporate profits over the next 75 years. From that he concludes that for equity investments to return 4.6% annually over this period, price earnings ratios would have to rise to 140X or about seven times higher than they are today.

Dr. Baker proposes the “No Economist Left Behind Test” to illustrate this point.

It asks what combination of price appreciation and dividend yields will provide the return that he says private account proponents need to make their plans succeed.

I answered that question last week but Dr. Baker takes issue with the column [Challenging Seiffe's arithmetic on social security reform debate (May 16, 2005)] and asks that I use this week’s to discuss the implications of the answer.

Fair enough.

To help understand the question, reducing Dr. Baker’s point to an example is helpful.

Consider a share of common stock earning one dollar and selling for $20. Using my trusty HP11 calculator and punching in the CBO’s 1.9% profit growth projection, I figure the company will earn $4.10 in 2080. To return 4.6% in capital appreciation, my calculator says the share price have to rise to $583, from $20, by 2080. At that point, the price earnings ratio would be 142X.

So, I won’t quibble with Dr. Baker’s arithmetic but I reject his premise and its implications. History, investor behavior and political motive are much more important indicators than the arithmetic.

History shows that during almost any point-to-point holding period, simple buy and hold strategies have produced yields that dwarf the “returns” Social Security will likely provide in the future.

In last week’s column, I investigated three periods that conventional wisdom would think the worst time to invest in the market.

These periods included one starting on the day the market reached an all-time high just before the 1929 Crash and at two other times the market crested at all-time highs in 1972 and 1987. The arithmetic average return for the three periods was 7.2% and, in each case, the yields were adequate to meet the investment objectives privatization proponents say is necessary.

Investor behavior is another factor that makes me suspect the CBO’s projections on which Dr. Baker’s point rests. Millions of 401(k) plan owners show the contrast in how they handle their assets and how the government handles their financial “assets”.

Private capital flows to more promising investments and away from declining situations. Public capital-in its many forms of aid, subsidies and taxes---are often directed to preserving declining industries and stymieing new ideas. In the case of Social Security “assets”, we understand they sit in filing cabinets and do not create new businesses or jobs beyond the deficit government spending they represent.

Widespread ownership of equities will have two other beneficial effects. The first is that huge, new flows of funds to the capital markets will lower the cost of capital. This will make new, higher risk-higher return business ideas possible and, yes, raise Price/Earnings ratios. Not to 140X like we saw during the Internet Bubble during the Clinton years (when Democrats believed in private accounts) but 30X is certainly possible.

The second implication is that near-universal ownership of equities will create political pressure to increase the returns on those--and all other private--investments.

If this simple analysis represents real market returns, (and my research says it under-estimates actual performance), then the Congressional Budget Office predicts equity returns will fall by three-quarters over the next lifetime. Frankly, the owners won’t accept a 1.9% long-term rate of return and will change the Congress that does.

It’s this second implication that explains the Social Security debate best. The problem is not whether returns on private investments exceed the kindness of the American taxpayer; the real problem is declining demand for government. With net worth and an ownership stake in America, folks regard their government differently. When they become the target of expanding government rather than the beneficiary, they will begin to say “no” and no is a word Washington doesn’t like very much.

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Ralf Seiffe advises business start-ups and product launches from Chicago, Illinois and is a political analyst and columnist for the Illinois Leader.