January 21, 2005

#174: Why Did Krugman Miss This Potential flaw?


In The Free Lunch Brunch (01/21/05) Paul Krugman almost gets it right. There is indeed a potential flaw in the President's transition plan to private accounts, but Krugman can't seem to find it. In this report we will first explain the potential flaw, then show where Krugman missed it (close, but no cigar!).

The Potential Flaw

As money enters the stock market from the funding of private accounts stock prices will be bid up. This is no problem as long as prospective earnings also rise so that the price-to-earnings ratios (P/Es) stay approximately the same during the funding. But unless the new money comes from increased savings there is nothing to drive earnings higher. In other words, if the private accounts are funded by borrowing rather than saving there is no diversion of national product away from consumption and into plant, equipment, technological research and all the things that promote economic growth. The result is that the private account holders end up owning stocks at inflated P/Es and will have years of lackluster returns to look forward to.

We have been careful to use the word "potential" to describe this flaw because some very smart people have thought long and hard about these issues and see them differently. For one thing, after the transition is complete further funding of private accounts would not require borrowing and would result in additional savings. One might also claim that even if stock returns are lower for the private accounts than the historical average they could still be substantially higher than the return associated with the current Social Security system. Finally, private account holders would at least own and control their accounts and that is worth a lot compared to the current system.

In a nutshell, we don't agree among ourselves on many of these issues, but we do think the borrowing vs. saving link to earnings and economic growth should be part of the debate.

So Why Did Krugman Miss It?

Probably because he is so intent on being mean and nasty that he can no longer think straight. He believes the Bush plan will fail because current stock holders are not stupid enough to swap their stocks for bonds, i.e., the bonds being issued to fund the transition.
Here's how he put it:

"So privatizers are in effect asserting that politicians are smart - they know that stocks are a much better investment than bonds - while private investors are stupid, and will swap their valuable stocks for much less valuable government bonds. Isn't such an assertion very peculiar coming from people who claim to trust markets?"

This gives Krugman a chance to take a swat at privatizers for hypocritically trusting politicians more than markets. But, in fact, the real problem is that Krugman doesn't understand markets. Of course current stockholders will give up their stocks for bonds if P/E ratios are bid up to unsustainable levels as we described above. Current stockholders will make out very well, thank you very much. It's the new private account holders with overvalued stocks backed by additional government debt rather than savings who will suffer. This is the point Krugman should have made, but apparently he doesn't even understand it.

Posted by John Weidner at January 21, 2005 10:46 AM
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