The Democrats, social security and the equity premium puzzle
Gerard Jackson
The Bush administration's proposal for social security accounts invested in the share market has been harshly attacked by Democrats. Politics aside, a difficult thing to do when dealing with the ideological likes of Teddy Kennedy, we should examine the basic criticism of the Bush proposals.
Critics assert that only the current system — which amounts to a gigantic Ponzi scheme — can guarantee a future income for Americans in their retirement. Investing in the market will cause severe fluctuations in pensions because the market is unstable.
That fluctuations occur is indisputable. However, what matters is the long-term trend — and that trend beats the pathetic returns of the current system. To explain why I think we need to take a look at the so-called equity premium puzzle.
A great many are puzzled by the difference in returns to equities and bonds. Some have tried to explain the difference in terms of risk. Bonds provide a steady income while equities are volatile, hence the risk premium. Others have correctly pointed out that the magnitude of the difference significantly exceeds any reasonable estimate of risk.
Glassman and Hasset apparently believe that the difference is accounted for by investors irrational behaviour in demanding an excessive risk premium. It follows from this view that markets have been undervalued for years because the excessive estimate of risk by investors has kept stock prices below their true value. Therefore, once this fact is realised the risk premium will fall and stock prices will surge.
Now according to the efficient market hypothesis markets have near-perfect knowledge. But if this were so, argue the critics, then the risk premium would virtually disappear and the return to equities would approximate to the return on bonds.
True. So what's the problem, or should I say puzzle? There isn't one. The fault lies in the approach. The apparent paradox arises from the error of applying general equilibrium thinking to market processes, i.e., static analysis to a dynamic situation.
Bonds are simply fixed interest securities while equities are shares in companies. Let us now look at the basic difference between them. Buying a bond is the equivalent of lending money at a fixed rate of interest. The bond itself is not an entitlement in the sense that equities are.
Buying equities is the same as buying entitlements to capital goods employed by the firm that issued the shares. As the value of the company is the sum of discounted anticipated earnings, it is clear that the value of the share will vary with the anticipated earnings stream.
It should be equally clear that there is no reason whatsoever for the return on bonds to correspond with bond returns. The belief that they should rests on the tacit assumption that they are in a state of perfect competition.
In such a state all returns are equalised and correspond to the rate of interest; all participants have perfect knowledge; adjustments are swift if not instantaneous; there are no profits or losses.
In the real world markets exist because man does not have perfect knowledge. Thus the role of the market is to coordinate and distribute masses of incomplete knowledge to market participants who will then act on it according to their own expectations and experience.
This brings us to the nature of profit and its effect on shares. In genuinely progressive economies — those that have rising per capita investment — aggregate profits always exceed aggregate losses.
Now if firms are consistently making profits then the value of their shares must be steadily rising, which means that equity returns must exceed the return on bonds. The reason is the nature of profit.
Professor Ludwig von Mises stressed that profits are maladjustments between supply and demand. In this situation factors are underpriced in relation to the value of their products. Therefore profit equals any return over the rate of interest plus any attendant risk.
Once we understand the nature of profit we realise that for equity returns to equal bond returns the economy would have to be in equilibrium. Obviously, the difference between bond and equity returns is just good old fashioned profit. The only mystery here is why anyone should think there is a mystery.
It follows that if the difference between these returns is really profit, as I believe I have shown it to be, then this becomes a strong argument for allowing Americans to invest part, if not all, of their social security contributions in the market.
After all, what matters from the point of view of retirement is long-run returns and not short-run fluctuations.
My argument obviously does not apply to those who are too old to benefit from social security accounts.
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 27 September 2004