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.