Would you invest in an economy growing just 1.7 percent annually? That's the question opponents of Social Security privatization are asking, since Social Security's trustees assume the economy will grow over the next 75 years at only half its historical rate. Under such conditions, say critics such as Dean Baker of the Center for Economic and Policy Research, stocks can't return anything like the 1926-97 average of 7.2 percent. Returns any higher than 3.5 percent, Baker says, are "simply inconsistent with the Social Security Trustee's growth projections." Characteristically, Vice President Gore straddles this issue: his campaign use this argument to attack George W. Bush's personal accounts plan, but Gore assumes historical stock returns when promoting his own supplementary investment accounts. Opponents of privatization issue press releases challenging advocates of market investment to predict future stock market returns, but stock market evidence from around the globe suggests that the relationship between economic growth and equity returns is more complicated than critics claim and that significant long-term market underperformance is unlikely.
As baby boomer retirements and low birth rates reduce labor-force growth to just 0.2 percent annually, total economic growth will decline as well. The critics' argument is simple: Slower economic growth means lower corporate profits, and profits drive stock prices; hence, stocks can't possibly return more than 3.5 percent, placing their long-term returns below today's government bond rate. While even this performance would substantially exceed Social Security's paltry 2 percent return, higher stock returns would speed the transition to personal retirement accounts.
But it's easier to say "slower economic growth equals lower stock market returns" than it is to prove it. Research by Philippe Jorion, professor of finance at the University of California-Irvine, reveals both theoretical and empirical flaws in Baker's argument. Jorion acknowledges the bookkeeping idea that "asset prices should grow at the same rate as cash flows," but in the real world "this relationship ... may be blurred by a number of factors." A more sophisticated theoretical model shows that returns on capital investments "should be related to real GDP growth per capita, instead of total GDP growth."
Jorion's empirical analysis confirms the theory. Drawing on research on global equity markets he conducted with Professor Will Goetzmann of Yale, Jorion examined the relationship between economic growth and stock returns for 31 countries, ranging from established markets to new economic powers to developing countries. The results directly contradict what Baker's theory would predict. While Jorion found "no observable relationship between stock market returns and GDP growth," statistical analysis revealed that "stock market returns are positively correlated to GDP per capita growth."
For instance, developing economies grew 1.4 percentage points faster than economies of developed countries, but their stock returns averaged 2.6 percentage points below those in the developed world. How could this be? Developing economies expanded through rapid labor-force growth, not productivity improvements. As a result, their GDP growth per capita — and their stock returns — lagged behind those of developed countries. Hence, Jorion concluded, "Lower capital gains are really associated with lower per capita economic growth," not lower total economic growth.
This link between per capita GDP growth and stock returns affects the debate over personal accounts, since the economic slowdown projected by Social Security's trustees stems almost entirely from reduced labor-force growth. Productivity increases — the other main component of economic growth — will remain at the 1969-98 average of 1.5 percent annually and GDP per capita growth will be respectable. Jorion found that a 1 percent change in per capita GDP growth correlates with a 0.7 percent change in equity returns. If true, we can expect future stock returns to be less than one percentage point below their 1926-97 average of 7.2 percent.
Of course, the real benefit from reforming Social Security through personal accounts is not simply higher rates of return. It is increased savings, the building of wealth and the independence that comes from personal ownership and control. But historically high market returns will make the transition to a system of personal accounts easier and will lead to a lower tax burden and higher retirement incomes in the future.
Nineteenth-century biologist T. H. Huxley declared, "The great tragedy of science is the slaying of a beautiful theory by an ugly fact." History confronts Social Security opponents of personal retirement accounts with particularly unattractive facts. It is ironic that these critics badger reformers to predict stock returns in the future, when their own theory couldn't even have predicted them in the past.