Monday, January 24, 2005

# Posted 6:02 PM by Ariel David Adesnik  

STOCK ANSWERS FROM KRUGMAN: Reader AG, who knows a lot about this subject, has provided an insightful response to my earlier comments on Paul Krugman and the stock market:
It's impossible to cram serious analysis into an op-ed column, and this sometimes gets Krugman in trouble. In fact, you're both right.

Stocks are riskier than bonds. There have been periods, as you point out on your BLOG when stocks have done poorly. (Your example of the 1970s isn't a good one, though, because bonds were also performing horribly at the time as inflation and interest rates skyrocketed.) So no rational investor would buy stocks unless he or she expected a higher return on equities than on fixed-income securities.

Careful analysis of the relative returns and risks of bonds and stocks over long periods of time (e.g., the 20th century, the post-WWII period) indicate that the excess return of stocks over bonds has been greater than one would expect just given the relative riskiness of the two asset classes. This extra risk-adjusted return on stocks is referred to as the "equity risk premium." Such a premium is something like a free lunch for equity investors. The point Krugman is making is that this premium is unlikely to be as large in the future as it was in the past. That's probably true, too.

Why is this relevant? The question being debated is: "The level of average economic growth over the next 50 to 100 years held constant, how likely is it that distant future retirees and taxpayers would be better off under the Bush plan (whatever it actually is) than they would have been under the current system?" If the forward looking equity risk premium is still high, then partial privatization will look good in retrospect. If not, not. No one knows. And, from the point of view of the next generation of Adesniks, it almost doesn't matter.

When you look at this issue this way it's easy to see that this whole debate, while in the center ring politically, is an economic side show. How well off retirees and workers are in the future absolutely depends much much more on how fast the economy grows between now and the distant future. One of the most important ways in which the Federal government can create a growth-friendly policy environment is to keep its overall fiscal house in order. But getting that right involves dealing with the bigger, nearer-term issues like the government's structural operating deficit and medicare.

More broadly, American's want European social public services, Japanese taxes, and the savings rate of an undergraduate. They can't have them all, and the Bushies have decided to go after social security first because dealing with it requires no short-term pain and because Asian central banks seem willing to buy as much of our debt as we can produce.

So the real problem with Bush's proposal is not that it is or isn't a good idea in the very narrow sense of what the equity risk premium might be. No one can know that now or even make a good guess. The real problem is that the whole thing is a distraction.

The reason for despising this policy initiative is not that the Administration is overstating the equity risk premium but that the right way to deal with our fiscal problems is to raise taxes, preferably on gasoline, and right now.
Now that OxBlog has a car, it doesn't like gas taxes. So let's tax the wealthy instead! (NB: OxBlog reserves the right to reverse this proposal should it become wealthy at some point in the indefinite future.)
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