Trump Accounts and the No Economist Left Behind Test
Back when George W. Bush was doing his big drive to privatize Social Security, I got upset because he was using bogus numbers that grossly exaggerated what his private accounts would yield. The basic story was that his team assumed that stocks would provide the same returns they had in prior decades, even though the price-to-earnings ratios in the stock market were far higher than in the past, and projected GDP and profit growth were much lower. Given the assumptions being used on profit growth, their assumptions on returns were virtually impossible.
To illustrate this point, I developed the “No Economist Left Behind Test.” This challenged economists to write down two numbers, one for dividends and one for capital gains, that added to their 10 percent assumed stock returns (7 percent real returns). (For the young’uns, Bush had championed “No Child Left Behind” as the slogan for his education policy.)
I wanted to challenge the return assumptions to effectively take their money away. If the Bush Team could get away with promising an impossible bonanza from their accounts, privatization would look much better than it actually is. It was important to set the record straight.
The test is supposed to be insultingly simple. Economists who can do all sorts of complicated math and statistics should have no problem writing down two numbers that add to 7 percent real return. But no one could do it for the simple reason that they didn’t want to make themselves look stupid.
At that time, the price-to-earnings ratio (PE) in the stock market was around 25. This means that after-tax profits are equal to roughly 4 percent of the share’s price. GDP and profits were projected to grow roughly 2.0 percent annually for the 75-year Social Security planning period.
These were the key numbers. Do you want to say that stocks would give 7 percent returns by paying out dividends, including share buybacks, equal to 7 percent of their share price? That would mean paying out 175 percent of their profits to shareholders?
Companies that pay out more than all their profits as dividends are not going to be around long. Typically, companies pay out 60-70 percent of their profits to shareholders. With profits equal to 4 percent of the share price, this buys you annual returns between 2.4 to 2.8 percent, well below the 7.0 percent assumed by the Bush Team.
Do you want to make up the rest of the 7.0 percent return with a rising share price? Okay, then inflation-adjusted stock prices will have to rise between 4.2 percent and 4.6 percent a year.
If that doesn’t seem like a big deal, remember that profits are only growing 2.0 percent annually after adjusting for inflation. Using the lower 4.2 percent stock price growth figure, the PE would have to rise to 31 after ten years, to 38 after 20 years, and 73 after 50 years. No one wanted to put their names to these projections.
As I pointed out in a piece I wrote a few days ago, the current PE in the stock market is 33. This makes the arithmetic on stock returns even worse than in the Bush privatization days. The profits for an average share of stock are equal to 3.3 percent of its share price. If it pays out 60-70 percent of its profits to shareholders as dividends or buybacks, it would give a yield of between 2.0 percent and 2.3 percent between.
That would mean inflation-adjusted share prices would have to rise be 4.7 percent to 5.0 percent annually to give the assumed 7.0 percent real return. The current inflation-adjusted growth projections for profits are still roughly 2.0 percent. This would give us a PE of 43 in ten years, a PE of 56 in 20 years, and a PE of 122 in 50 years. Anyone want to put their name to those projections?
The key point here is, contrary to the way they are discussed in the media, stock returns don’t fall from heaven. They are related to the real economy. If someone is putting on a clown show, they can claim whatever stock returns they want, but if they want to be serious, they have to say where they come from. Do the No Economist Left Behind Test!
This first appeared on Dean Baker’s Beat the Press blog.
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