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February 02, 2005

Return To KrugWorld

A day ago the future had looked aching and desolate, and now it looked full of surprises and terror and bad things happening to people... If he had anything to do with it anyway.

-- Paul Krugman (aka The Death of Rats)

Amusement has been scarce on the ground since November 2nd and the half-vast editorial staff finds itself consumed with ennui. The usual Big Game has been skittish. We note with some glee that, windsurfing and other manly exploits being out of the question until the weather becomes more temperate, Jean-Fraude must while away the time by telling tall tales. Like Captain Ed, we noted the Khmer Rouge embellishment whilst compiling the last KerryWatch, but the list of Kerry's prevarications is now so lengthy that we confess ourselves quite worn down. He could have claimed to have photos of himself strapped into harness next to Rudolph the Red-nosed Reindeer at the North Pole on Christmas Eve 1968 and Tim Russert would have not have batted an eyelash.

And so it came about that in the chilly pre-dawn hours, armed with my favorite bunny slippers, a large mug of extra-strong coffee, a liberal splash of Balvenie single-malt, and an elephant gun I foolishly decided to return to KrugWorld...

The first sighting was on his usual stomping grounds. The Death of Rats was holding forth with his usual gloom. One often suspects he missed his calling in life. He could be making so much more money shilling for Glaxo-Smith-Kline as the Poster Child for anti-depressant research:

Schemes for Social Security privatization, like the one described in the 2004 Economic Report of the President, invariably assume that investing in stocks will yield a high annual rate of return, 6.5 or 7 percent after inflation, for at least the next 75 years. Without that assumption, these schemes can't deliver on their promises. Yet a rate of return that high is mathematically impossible unless the economy grows much faster than anyone is now expecting.

On what does the DOR base this contention? Gloomy as he is, the DOR is full of surprises - who knew he was a Magician? Watch him pull a rabbit out of his hat:

To get a 6.5 percent rate of return, you need capital gains: if dividends yield 3 percent, stock prices have to rise 3.5 percent per year after inflation. That doesn't sound too unreasonable if you're thinking only a few years ahead.

But privatizers need that high rate of return for 75 years or more. And the economic assumptions underlying most projections for Social Security make that impossible.

The Social Security projections that say the trust fund will be exhausted by 2042 assume that economic growth will slow as baby boomers leave the work force. The actuaries predict that economic growth, which averaged 3.4 percent per year over the last 75 years, will average only 1.9 percent over the next 75 years.

OK, let's take a look at that one again... Stay with me now, and watch both his hands closely:

1. For the plan to work, stock prices need to go up 3.5% per year.
2. The economy has grown, on average, 3.4% per year for the past 75 years.

Here comes the rabbit, folks...

3. For some unknown reason, "actuaries" now mysteriously predict that the economy will only grow by 1.9% - rather a dramatic drop, don't you think? - over the NEXT 75 years.

Now the interesting thing here is the Mr. Krugman "assumes" (and we all know what happens when you assume) that stock prices will grow at the same rate as the economy. He has pulled a switcheroo on you, hoping the alert reader will not notice. But someone else did, and fact-checked his sorry tuckus:

I went to Fidelity's webpage, which tracks all mutual funds (which is what privatized Social Security accounts would invest in). I asked it to give me all the Domestic Equity (i.e., mutual funds that invest in US stocks) funds that had an annual return of over 10%. There were 570 funds. Then I checked for funds that had an annual return of over 5%. There were 921 funds (including, of course, all the ones that had a return over 10%). Then, just for grins I checked for all funds that had an annual return of over 0% (that is, they had not actually lost money). There were 948 funds (which I believe is all the funds actually tracked), which of course includes all the funds with returns greater than 5% and those with returns greater than 10%. So breaking them out:
Return from 0% to 5%: 27 funds Return from 5% to 10%: 351 funds Return greater than 10%: 570 funds
It is not hard to see that almost anybody who had invested in mutual funds ten years ago would have been very unlucky indeed to have an annual return of less than 5%, as only about 2.8% of the mutual funds out there did that poorly. These returns are adjusted for fees. If you knock 3% off to account for inflation, over 60% of all Domestic Equity mutual funds exceeded 7% annual returns.

This Cato Institute paper on Social Security choice (via Steve Antler) confirms those numbers, putting estimated returns well over 3.5%:

Jeremy Siegel of the Wharton School, generally considered the leading expert on historical investment trends, estimates that the arithmetic returns to equities ranged from 8.5 percent (using the period 1802–1997) to 8.7 percent (using the period 1871–1997), and geometric returns of 7.0 percent over both periods.

Recently, a few critics have claimed that Siegel’s methodology has inaccurately inflated long-term market returns through “survivor’s
bias.” That is, Siegel’s sample includes only companies that have survived. Failed companies, those that went out of business, are dropped from the calculations, thereby inflating rates of
return.39 Some financial analysts have suggested that fully accounting for survivor’s bias would reduce historic rates of return by about 0.7 percent over short periods and as much as 1 percent
over periods in excess of 15 years.40 Siegel himself
admits that his estimates for pre-1900 returns may be overstated by as much as 1 percent.

However, the 19th century was a period of far greater financial and corporate instability. The further one goes into the 20th century, the
less that survivor’s bias distorts results. In addition, Siegel’s estimates also do not include recent years that have seen both increased volatility and steep declines in the stock market. Therefore, a better benchmark of past returns might be
Ibbotsen Associates’ estimate for the S&P 500 from 1926 to 2002,
providing an arithmetic average annual real rate of return of 9.0 percent and a geometric return of 6.9 percent.

Apparently this kind of cutting-edge research was not available to the smart folks at the Krugman Institute for Creative Statistics Economic Studies.

Although we are delighted to have the opportunity to take potshots at the DOR, we confess that we are also a tad perplexed: we thought he was taking a sabbatical? Why does he keep popping up like a demented Whack-A-Mole to jabber about Social Security? Don Luskin deftly administers a few taps with the Clue Mallet:

Look up the word “vile” in the dictionary and you will find an appropriate description of Paul Krugman’s New York Times column from last Friday.

[Ed. Note: Good Lord... how did I miss this one???]

In the column, America’s most dangerous liberal pundit throws a gutter accusation of “bigotry” at President Bush — yes, the man who just appointed his female African American national security advisor as the successor to his African American secretary of State.
Krugman quotes Bush saying that “African-American males die sooner than other males do, which means the system is inherently unfair to a certain group of people.” Krugman says Bush made this statement “[t]his week, in a closed meeting with African-Americans.” Krugman is wrong: Bush made this statement on January 11 in an open meeting with Americans of all races. And Bush is right — according to the National Center for Health Statistics, at age 65 the median African American male lives 14.6 more years, compared with 16.6 more years for whites. That means African Americans have 2 fewer years to collect their Social Security benefits than whites do, even though they pay the same amount of taxes during their working lives.

For heaven's sake, Bush is such a racist. Why on earth would a ReichPublican want to create wealth for black families in America? Perish the thought. Far better to keep them on a measly stipend from the federal government with no prospect of bettering the return through intelligent investment:

Personal accounts will make Social Security more fair for African Americans because, at death, the value in those accounts will be allowed to be passed on to loved ones — not just plowed back into the system, as is the case today. But Krugman says Bush is bigoted for wanting to redress that injustice. In Krugman’s mind, Bush is treating “premature black deaths not as a tragedy we must end but as just another way to push [his] ideological agenda.”

In KrugWorld, we are all equal. It is just that animals are more equal than others, and Mr. Krugman would like to keep it that way. Could someone please pass the Balvenie?

Posted by Cassandra at February 2, 2005 06:25 AM

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Well, ANY rate of return would be better than the one we're getting now, which is--what's that word again--ZERO.
A pension fund that was run the way Social Security is run would have its staff up on charges.

Posted by: MrsPurpleRaider at February 2, 2005 10:30 PM

Thanks for the link to Lifelike! I have been thinking about how an investment in stocks (or in mutual funds investing in them) could grow faster than the underlying economy, and it seems obvious that one method is for companies to use debt. This is quite common in the commercial real estate transactions I am involved. If you buy a property at a 9% return and it (and the income stream) appreciates at 4% per annum, then your yield will be 13% per annum. But if you leverage the purchase with debt the returns can quite often end up substantially higher.

Posted by: Pat Curley [TypeKey Profile Page] at February 3, 2005 01:54 AM

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