Arnold Kling  

Politics vs. Economics

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Economics of Content... Labor Market Puzzle...

On one of the comment threads, a reader asked me if I disagreed with the economics of Lawrence Kudlow.

"Honestly, I never thought he had any to disagree with," was how I began my reply. Let me revise and extend my remarks.

I think that it is common to assume that there is a "conservative economics" and a "liberal economics." But I think of politics and economics as being on different dimensions. When I listed five economists at different points on the political spectrum in Real World 101, I did not mean to imply that we differ on economics. I think we all still use similar models. That is part of what makes trying to explain our political differences such a speculative exercise.

Let me walk through two issues as examples. I will talk about Social Security on this post, and then add a second post on supply-side tax cuts.

Social Security

I think that from an economic perspective, the best way to describe the Social Security problem is generational accounts. See my primer on Social Security policy.

More important, I take seriously the golden rule for economic growth, which implies that the return on capital is likely to be close to the growth rate of the economy. And even if you do not buy that, I believe that Stein's Law precludes stock prices from rising faster than the economy indefinitely. (Herbert Stein's Law is that any process that cannot go on forever, eventually stops.)

There are conservatives who argue vehemently--although not explicitly--against what I see as the implications of the golden rule or Stein's Law. For example, see Peter Ferrara, with whom I imagine Kudlow would agree. I doubt that Kudlow has the first clue how to write down any sort of model of stock market returns embedded in an economic growth framework, much less produce such a model that generates stock market returns far in excess of economic growth.

Having said all that, politically my views are probably closer to Kudlow's than they are to those of, say, Robert Solow. The notion of collective responsibility for the income of the elderly has more appeal for Solow than it does for me. Still, his economic analysis of the issue is one with which I would not quarrel.


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COMMENTS (4 to date)
Jim Glass writes:

"I take seriously the golden rule for economic growth, which implies that the return on capital is likely to be close to the growth rate of the economy. And even if you do not buy that, I believe that Stein's Law precludes stock prices from rising faster than the economy indefinitely. (Herbert Stein's Law is that any process that cannot go on forever, eventually stops.)

"There are conservatives who argue vehemently--although not explicitly--against what I see as the implications of the golden rule or Stein's Law. For example, see Peter Ferrara..."
~~~

I still don't see what's supposed to be the contradiction between the two views.

The *compound* rate of return on capital cannot permanently exceed the growth rate of a closed economy or eventually it will become 99.9% of all income, which seems unlikely.

But the simple rate of return on capital can exceed the growth rate of the economy indefinitely, both as a matter of logic and of the evidence that it has actually solidly done so for 200 years -- which is pretty much 100% of the post-Industrial Revolution period -- if one believes the data from the likes of Siegel, who hasn't been kicked out of Wharton yet AFIK. (And isn't there some sort of law to match Stein's along the lines of: "if something has actually occurred for 200 years this is evidence that it is possible"?)

There's no contradiction here because people consume their savings in the end -- that's why they save, to be able to consume later. So investment returns do not fully compound. Thus, stocks can give a consistent 7% long-run real return for 200 years (as they have) because they compound in value at only about the 3% real growth rate of the economy (as they have for a hundred years) after people spend about 4% of that return through dividends and stock redemptions.

Hey, everybody's satisfied! "Stein's law" is satisfied because investments do not and (have not) compounded much faster than the growth rate of the economy. Ferrara is satisfied because a portfolio of stocks and bonds will grow in value at a substantially faster rate than the growth rate of the economy *for those savers who choose to have them compound* -- re SS, persons in the working & saving portion of their lives -- just as it has the last two centuries.

So there's no conflict between savers getting a higher return than the growth rate of the economy on their investments, and the growth rate of the total value of all investments *not* exceeding the growth rate of the economy -- one just needs to remember that their are people running down and consuming the value of their investments at the same time as others save.

ISTM any "vehement disagreement" regarding all this is likely just based on some version of the Dow 36,000 fallacy. The only way that the value of savings represented in stocks and bonds would compound at their full simple rate of return --- thus creating a "Stein" problem -- would be if everybody always reinvested 100% of the income they produce and never cashed any of them in. But if nobody was ever going to use any of their savings, why would anybody save?

Arnold Kling writes:

Jim,
You write as if the problem with assuming 7 percent returns is that people will accumulate too much savings. That is not the problem.

The problem is: how can firms generate enough profits?

Let's assume that stocks pay no dividends. So, all the returns are in the form of capital gains. Consider the ratio of the price of stocks to GDP. That ratio has to rise indefinitely if stock returns are 7 percent and GDP grows at 3 percent.

If the ratio of the price of stocks to GDP is to grow indefinitely, then either the P/E ratio must grow indefinitely (which eventually would mean a negative risk premium) or the ratio of earnings to GDP must grow indefinitely (which would mean they would get beyond 100 percent of GDP).

It's just not possible. What has happened over the past 200 years is that (a) the corporate sector of the economy has grown from almost nothing to around 50 percent of the economy and (b) the risk premium declined from very high levels. Going forward, the corporate sector cannot increase by another 50 percentage points! And if the risk premium has gone from, say, 8 percent to 3 percent, it is not going to drop another 5 percent and be -2 percent!

Jim Glass writes:

"Jim,

"You write as if the problem with assuming 7 percent returns is that people will accumulate too much savings. That is not the problem."

Agreed, it's not, you're still missing my point. Maybe some data will clarify it.

"If the ratio of the price of stocks to GDP is to grow indefinitely, then either the P/E ratio must grow indefinitely (which eventually would mean a negative risk premium) or the ratio of earnings to GDP must grow indefinitely (which would mean they would get beyond 100 percent of GDP). It's just not possible. "

But the ratio of the price of stocks to GDP has *not* grown while stocks have returned 7% real annually on average over the last century. And there is no need for it to do so in the future for investors to continue getting such a return.

E.g., the DJIA in 1926 was around 150, which inflation-adjusted for today is about 1,500. Now it is about 9,500. That's an annual appreciation in stock values of only about 2.4% -- less than the growth rate of GDP.

Over the same period the S&P 500 went from 13.5, or about 135 inflation-adjusted, to the current approximate 1,000, or a tad over 2.6% annually --- also less than the growth rate of GDP.

The rest of the 7% return from stocks was in dividends and stock redemptions, the proceeds of which weren't reinvested in stocks.

There is no requirement that the value of all stocks grow by 7% annually for stock owners to get a 7% current return from them, any more than there is for the total value of all corporate bonds to grow, say, 6% in value annually for investors in bonds to get a 6% yield from them. The total value of all bonds issued can decline as investors get their 6% return. Stocks are just bonds with a rate of return that is more variable (their return being the residual left over after bondowners, etc., are paid).

"Let's assume that stocks pay no dividends. So, all the returns are in the form of capital gains. Consider the ratio of the price of stocks to GDP. That ratio has to rise indefinitely if stock returns are 7 percent and GDP grows at 3 percent."

But stocks do pay dividends, and firms have always paid out the bulk of their earnings one way or another to their owners. (Via dividends until as late as around 1990, IIRC, when the tax law began penalized them and firms switched generally to making payouts through stock buy-backs.) Which is why the DJIA and S&P 500 have appreciated at only 2.4% - 2.6% real annually over the long term.

The scenario that stocks pay no dividends and thus compound a full 7% annually is equivalent to 100% of dividends being reinvested perpetually. But in that scenario no business owner ever gets to take and spend even one penny of the net profits of any business. If business owners can never receive any of the earnings of any business, why do they invest in businesses? What keeps the stock price up? It is illogical, and 7% compounding of stock prices is contra-factual.

To the extent that owners do help themselves to the earnings of their businesses, rather than reinvest them in the business, the annual return to them will remain unchanged but the growth rate of the value of their businesses will fall. It's really no different than bond investors who receive a 6% yield spending 4% of it and reinvesting 2% in bonds. They can get that 6% yield, which is greater than the growth rate of the economy, forever, but the value of their bond portfolios will grow at only a 2% rate.

I am a black republican, grant it, I don't agree with all my parties lines, but I do feel like they believe in rewarding for those that want to achieve. This is the main reason I side with the republican.

My point is that the African-Americans (Blacks) here in the south are well known for siding with the left, and all the whites around here assume I am a democrat because of my color and that is sooo dis-respectful. But I don't blame the whites, I blame my people... because we are followers and not leaders. True black leaders vote Republican.

So how does it make you feel that eveyone around the nation assumes that those from Mass are liberal? That would offend me beyond belief, and I would do all I can to so ul search to make sure I am not complacent in life. I would make sure that I am not penalizing people for wanting to succeed.

And then vote from the heart, whether left or right.

Thanks for letting me voice my 2 cents.
-Dave

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