Thursday, September 21, 2006

Demographics and Acorns

In Wednesday’s Wall Street Journal Jeremy Siegel (cited by Greg Mankiw) argues that demographic trends (the increasing fraction of older people among the populations of developed countries) will doom future US retirees unless developing nations are willing to start buying US assets:
Instead of stepping into an easy retirement, many retirees will tumble into a future marked by bankrupt government social programs and declining asset values that will quickly deplete their cherished nest eggs….This forecast is not based on an unpredictable future, but on events that have already transpired.
Well, OK, the demographics are based on events that have already transpired, but demographics are only part of the story, and in order to get the outcome Prof. Siegel suggests, the unpredictable future has to turn out in a certain way. In particular, productivity growth is unpredictable, and future saving behavior is unpredictable, and if they both turn out better than Prof. Siegel expects, or if one of them turns out a lot better than Prof. Siegel expects, then at least some of those dire consequences will be avoided.

There are a lot of issues here to wrap ones mind around, so I may have several posts on this subject, but let’s start on the asset value issue and go for now until I run out of steam. Prof. Siegel argues that retirees will want to liquidate assets and, with so few working-age people around to buy those assets, there will be little demand, and prices will decline. I wouldn’t rule out that scenario, but I have several problems with it.

The first is a basic theoretical problem. Asset returns should depend on two things – time discounting and the price of risk – but I don’t see why either of these things should be affected by future demographic conditions. A risk-averse person investing for retirement today can choose to invest in bonds and annuities which will provide a return – through the time of their retirement – that is known with near certainty in advance. These assets can be chosen to mature at exactly the right time, so there is no need to worry about finding buyers. Thus any demographic issues that might exist are already priced into the safe assets. As for risky assets, their price today should be based on an expectation of what their return will be relative to the safe assets. If current prices don’t allow for a sufficient return, enough to compensate for the return on the safe assets and provide a premium to compensate for the risk, then why would anyone buy them?

OK, maybe someone will buy them because they haven’t read Prof. Siegel’s research and don’t realize how low the returns will be. But I still have a problem. If the asset returns are going to be so low, then people are saving way too little today. The way to make up for low asset returns is to save more. Presumably, people will eventually realize this and start saving more. But when they do start saving more, the demand for assets will go up, and presumably asset prices will go up. So the story about low asset returns is not actually a story about today’s investors; at best it’s a story about future investors, the ones who buy after asset prices go up.

And there’s a further issue. According to Prof. Siegel,
In a modern economy, wealth does not represent “stored consumption,” such as a cache of acorns that squirrels bury to bide them through a long winter. You cannot consume your stock certificates, but must sell them to someone else who wants a chance to consume at a later date. If there is a shortage of these savers, this may cause a long and painful bear market in stocks, bonds and real estate that will leave retirees with insufficient assets to enjoy retirement.
But in an important sense, wealth does represent stored consumption. Stocks, the most important type of risky asset, represent ownership in a productive enterprise, and most productive enterprises have a depreciation aspect. A stock does not represent an infinite stream of dividends subject to the market’s valuation; it represents a finite stream of physical returns. If people purchase stock, corporations will make physical investments that will produce physical returns to take care of those people during retirement. Granted, the return on physical investments will tend to fall as more and more such investments are made, but there is no reason to believe we are reaching a point of severely diminishing returns any time soon.

OK, I’m out of steam, for today.

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Blogger Gabriel Mihalache said...

Huh... these are difficult issues. Saying that prices/rates already reflect that information is the kind of thinking that leads to Ricardian equivalence. So I think we must allow for a dose of imperfection in the way prices reflect context. I don't know.

Also, could you please expand on your comment regarding shares? I thought that shares entitle you to dividents in perpetuity, or at least as long as the company exists. When the company sells more, their value depreciates, but ignoring this, I don't understand what you mean by finite stream of physical returns.

Regarding diminishing returns to investment... technological progress might keep us permanently away from that point where further investment is unprofitable. I think that technological change has potential in helping the retirement and social security problems of western nations.

I always thought that these kinds of problems are easiest tackled by writing a steady state condition for a growth model (ex: with exogenous technological/TFP progress) and then see which increses/decreases in which rates can offset the decrease in population growth.

Fri Sep 22, 01:10:00 PM EDT  
Blogger taylorfedrates said...

Hmmm, but knzn you forget that some assets are priced worldwide- and our local effects in terms of assets can be overcome in those terms. Swiss francs, gold, fungible commodities. Maybe the best investment will be in soybean producing companies that export to the far east.

Should the dollar drop, the US gdp will continue to fall in real terms, but will most likely continue to expand in nominal terms, as has most likely been the case since 2001.

Now, as the future is totally opaque, and the fed response is guaranteed to be lowering rates to mitigate the housing crash, one can almost make a long (and I emphasize long 25 year!) bet against the dollar and into emerging economies and natural resources rich economies.

Our current situation seems to correspond to France before the revolution- printing assignats and fighting bankrupting wars.

The Boomers will influence retirement in this country beyond their wildest dreams...but I fear they will perceive it as a nightmare.

Who is going to buy all of those stocks from all of the boomers when they sell? Well, if you believe in Ricardian equivalence, they will be worth a marginal product of the net savings rate of the country. Think through the vast tax increases that will be necessary to minimally fund the social insecurity and medicare fiascos.

No savings rate? I predict much lower asset prices- at least in real numeraire terms. The fed didn't get really serious about keeping the rate hikes going until the metals markets joined the housing market in a near parabolic ascent.

Fri Sep 22, 03:10:00 PM EDT  
Anonymous Thomas Wood said...

First - love your blog. Definitely my new favorite out of all the econ blogs.

I don't find the theoretical view on asset returns helpful. I realize that Prof. Siegel uses phrases such as "who will buy these assets", but I presume his real point is about any dollar asset - including cash. And that this dollar asset, cash or otherwise, is going to have relatively fewer US-produced goods and services to purchase, because fewer people will be work. However, provided we can import the difference we'll be fine. Is that essentially what he's saying? If so, I find it more helpful to focus on real economic growth home and abroad rather than the pricing of financial assets, which I presume the market is generally pricing better than any one individual can.

Fri Sep 22, 03:38:00 PM EDT  
Blogger knzn said...

Gabriel, I think I’ll discuss the point about dividends and physical returns in my next post, because I do have a more substantive argument that I glossed over for lack of time (and to avoid too long a post).

Regarding technological progress, it sure helps, but I don’t think it’s critical. The big question for me is how much substitutability there is between labor and capital in the production function. With a reasonable (say Cobb-Douglas) production function, I don’t think diminishing returns are going to be a big problem, unless the dependency ratio becomes really, really huge.

taylorfedrates, I’m not sure I understand what you’re trying to argue. There may be a case to be made specifically against US assets, but Siegel’s argument was really about the developed world in general. If people are worried about the dollar, they can always buy foreign assets and still fund their retirement even if the dollar drops. To some extent this drop is already anticipated in forward rates (or equivalently, interest rate differentials), in which case we should expect the local currency returns for US assets to be higher than for foreign assets (and we can see that safe local currency returns are higher in the US compared to other large economies). Also, there are TIPS available to get a guaranteed real return, provided that one trusts the CPI.

Thomas, Thank you. I agree that real growth is ultimately a more useful perspective than asset pricing, and I hope to address that in a future post. The op-ed was first brought to my attention by a colleague whom I suspect was more interested in the asset price implications, which are interesting in their own right.

Fri Sep 22, 05:30:00 PM EDT  
Blogger taylorfedrates said...

**taylorfedrates, I’m not sure I understand what you’re trying to argue. There may be a case to be made specifically against US assets,**
That is my point- US assets will not have enough support from a small cohort and stagnant real incomes.
Oh, yes and combined with higher taxes- hence my RE crack.

** but Siegel’s argument was really about the developed world in general.**
Same thing applies to everybody that has the same demographic wall in the first world- the Japanese look really grim with no immigration.

**If people are worried about the dollar, they can always buy foreign assets and still fund their retirement even if the dollar drops.**
Hence my advice to myself to keep on investing in those things- Now I need to find a Brazilian ADM stock that isn't getting stuck on their chinese exports.

**To some extent this drop is already anticipated in forward rates (or equivalently, interest rate differentials), in which case we should expect the local currency returns for US assets to be higher than for foreign assets (and we can see that safe local currency returns are higher in the US compared to other large economies).**

Totally disagree- many resource rich countries are *paying high rates* see everbank 6 month cds 10.5% for Icelandic Krona, 6.00% for New Zealand, South Africa, etc.- The lowest rates are in the first world- our current rates are a temporary response to propping the dollar in the face of ramping inflation- the fed will be easing just as soon as the ppi/cpi flavor de jure can justify in order to try and salvage the housing market.

**Also, there are TIPS available to get a guaranteed real return, provided that one trusts the CPI.**
About as far as I can hedonicly adjust my expectations in retirement to correspond to catfood instead of hamburger.

What I am trying to say is that because of the failure of Ricardian Equivalence- one of the things I was castigated for not believing in grad school- we are in a far bigger mess than we anticipate. The majority of the baby boomers have not sufficiently prepared for retirement, mentally or financially, so they will be unable to retire.

I find it ironic that the generation that has had the most influence on the current body politic fails so badly in protecting their interests.

Consider the raising of retirement age post Boskin- did they even really notice? I see a tremendous amount of retirement planning stuff passed out that seriously considers retirement commencing at 62- without even taking into account the changes in the retirement age and the discount function already built into the law. RE has flown out the door with the massive structural deficits and total accounting.

This is the external federal debt added since 9/1/01-to 9/21/06
This represents a 47.07% increase in the total debt outstanding.
As this rate the current administration will nearly double the total federal debt outstanding in only 8 years. (Actually I predict the doubling will happen in 2009- remember the offbudget contributions from Medicare will cease shortly.

Now, given these statistics, how can one realistically believe that a tips bond based on the CPI is ever going to retain any shred of value over the long run?

Hence my crack about assignats and fighting bankrupting wars. Our debt is starting an exponential growth cycle, just as we enter into a dynamic economic slowdown. That is why I am not enthusiastic about the dollar providing more than a temporary haven.

Fri Sep 22, 11:57:00 PM EDT  
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