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EMH&SS

February 16th, 2005

Matthew Yglesias had a well-argued piece a couple of days ago on Social Security and the Efficient Markets Hypothesis (EMH), in which he quoted me on the (generally left-wing) implications of rejecting the EMH. This spurred me to start on a post (or maybe a series) on the EMH, the equity premium and the implications for US Social Security reform. Most of what I have to say is consistent with what Matt and others have said previously, but perhaps there will be a bit of a new perspective.

I’m going to look at three plans[1]. First, the status quo, that is, a scheme where the Social Security fund is invested in government bonds and pays a defined benefit. Next, diversification, that is, investing the Social Security fund in a diversified portfolio of debt and equity, but still with a defined benefit structure. Third, privatisation private accounts personal accounts, that is, allowing individuals to make their own investments and reducing the defined benefit correspondingly.

The main reason the alternatives might yield substantial benefits is the equity, premium, that is, the fact that, on average, returns to equity have been much higher than returns to debt in the long run. So, it might appear that investing Social Security money in equity, either individually or through the Fund could yield better returns than the current policy of holding only government debt.

This post will be about the implications if the EMH is exactly, or approximately true.

The easy case is when the EMH is exactly correct. In this case, the equity premium is simply the market’s aggregate evaluation of the required premium for the additional risk involved in holding equity. The EMH requires that each individual hold their own optimal mix of risk and expected return at the prevailing market prices, and that they take full account of expected taxes, Social Security payments and so on.

Under the EMH, neither of the reforms will make a difference. If the Social Security fund shifts into equities, individuals will reduce their own holding of equity until the desired balance is restored. Moreover, individuals will be entirely indifferent about personal accounts. If forced to open them, they will, initially at least, invest entirely in bonds, so restoring their (by hypothesis, optimal) status quo ante.

One important point about the EMH that’s relevant at present is that the risk associated with the equity premium has to be real long run risk. If equity investors were guaranteed of coming out ahead over, say, 20 years, no significant premium could be sustained. So the US experience, where a 20 year holding period has almost always been enough must be somewhat atypical. Shiller makes the point that other countries have experienced longer periods of poor stock returns, while still exhibiting an equity premium.

A more interesting case is when the EMH nearly holds. Suppose that the market is efficient in most respects but that some people are credit-constrained or face high borrowing costs. As a result they can’t hold as much equity as they want, since they can’t borrow to get it. This gives a case for either of the proposed reforms, since directly or indirectly, this gives credit-constrained households exposure to equity.

Note however, that almost any violation of the EMH leads to interventionist policy conclusions unappealing to free-market types. For example, given credit constraints, it’s generally desirable to increase the consumption of the young, for example by subsidising post-secondary education. something that is commonly stigmatised as “middle-class welfare”. So, as Matt says, invoking EMH violations, implicitly or otherwise, is a very dangerous intellectual strategy for supporters of privatisation.

fn1. In each case, I’ll ignore the underfunding issue, the fact that Social Security taxes at current rates will eventually be insufficient to fully fund promised benefits, under current rules. Whichever scheme is adopted, some combination of lower benefits, higher Social Security taxes or general revenue support will be required.

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  1. February 17th, 2005 at 00:53 | #1

    Your footnote assumes as “fact” something that very possibly isnt. Ignore the underfunding issue by all means but recognize that many observers have noted that there may well not BE any underfunding issue at all. The SS actuaries posit a 1.9% growth rate over their 75 year projection period. Any observer of empirical reality has to admit the possibility that the actual outcome could well be higher than that – perhaps quite a bit higher. One piece of evidence in favor of this is that the growth rate for the PAST 75 years (Including the Great Depression) was 3.4%. That level of growth would entirely eliminate the underfunding issue. So you are just plain wrong to assume as a solid fact that “some combination of lower benefits, higher taxes or general revenue support will be required”. Entirely plausible assumptions about future growth show that isnt necessarily true.

    As to your larger point of the EMH I would like to point out something many seem to have ignored – Economists seem to assume that the social security issue is simply one of portfolio diversification – Insofar as it is, I have always looked at SS as my “risk free asset”, a view that will have to be revised now that eliminating it is on the table. However, the real reason we put it in place in the first place is because we dont like to have old and disabled people starving on the streets. This is an insurance function not just for the starvees but for all of us who like to imagine we live in a humane society. Regardless of whether it is true that there is money lying on the table to be picked up in the form of an equity premium it is true only ON AVERAGE. If we eliminate the floor support of SS we will simply have to reinvent it later when those starving people start to reappear on the streets – Unless by then we have all become so cold and heartless that we simply shut the doors of our gated communities.

  2. February 17th, 2005 at 04:15 | #2

    I hope you dont mind my having posted this over at Maxspeak, but I am putting it here because it was your post that made me think of it.

    A thought that may have been talked about elsewhere, but which I havent yet seen:

    The EMH is just fine in the small but not necessarily in the large. That is to say, it prices individual stocks just fine (most of the time) compared to all of the other stocks. What doesnt happen very well is pricing of overall systemic risk. And when we are talking about “trades” that are very large compared to the system (i.e. lets float a couple trillion in government debt so we can put the money in an index fund) then we are talking about something with potential systemic consequences.

    History tells us that we do a remarkably poor job of pricing such eventualities. To think otherwise is to think as has been mentioned elsewhere, that stocks were correctly priced in early October 1929, or just before the 1987 crash, etc. In the current situation it is exactly the danger of systemic instability that most worries me. To me, the possibility of picking up another point of return if it turns out that in fact there really is an equity premium to exploit is no compensation for the possibility that borrowing another $2 trillion could cause a worldwide financial crash. Most proponents of this idea seem to blithely assume that the other side of this transaction – the people who are going to actually lend us the money – are willing to do so forever more, in whatever quantities we want and at a price that doesnt affect our plans. But it the systemic consequence of doing this that is the really big money on the table, not the difference in return between bonds and an index fund. And I see no evidence at all that people in the capital markets are discounting for this.

    I may sound like Chicken Little. But the fact that a supposedly sane economist with extremely mainstream training is even worried about this at all (and I am not alone by any means) says that we are way closer to a problem than we ought to be. The government should be the one providing the risk free asset – NOT the one taking the flyer on a huge trade.

  3. anne
    February 17th, 2005 at 06:47 | #3

    John and Steven

    Fine post and fine critique. Imagine teaching a philosopher how to think “economics.” Thanks :)

  4. pgl
    February 17th, 2005 at 07:50 | #4

    I also posted this over at Angrybear as it so well makes the point I’ve been arguing. Note my link to Barro’s July 2000 Business Week oped who argued similarly.

  5. richard
    February 17th, 2005 at 07:53 | #5

    >>The EMH requires that each individual hold their own optimal mix of risk and expected return at the prevailing market prices>>

    You appear to be confusing EMH with individual rationality. EMH likely requires some investors to be rational, but it does not require all invesors to be rational. It is quite possible that many if not most individuals are irrational and hold terrible mixes, yet market prices reflect all available information.

  6. February 17th, 2005 at 15:24 | #6

    Why not look at age related mixed strategies? I addressed these in some articles at my publications page, particularly with regard to transitions.

    I did separate out the rearrangement/privatisation issues from the particular plans on offer and from the (distinct) demographic issues, which got an article of their own.

  7. Alex
    February 17th, 2005 at 20:19 | #7

    I take issue with the idea that government funded, defined benefit social security is a “risk free” investment. What about sovereign risk? Governments define the benefits in the first place, they can always redefine them. What about the propensity of past governments to solve their debt problems by printing money, thereby causing inflation and reducing the value of the defined benefit?

  8. February 17th, 2005 at 23:37 | #8

    Alex

    You are right about sovereign risk but in answer I have the following points
    1. There is no such thing as a perfect risk free asset
    2. If the US Gov. goes down then all bets are off – I am going to go buy a deer rifle and the solvency of SS is the least of my problems
    3. As for redefining benefits, yes that’s possible though it has never happened in a downward direction in my lifetime (or my parents’ lifetime)
    4. As for inflation, our current SS arrangements protect us from that. The benefit is indexed to wages up to the day you retire and then the CPI thereafter – So your benefit rises with the general standard of living until you are 65 after which it is constant in real terms.

    There is a somewhat Orwellian cast to Republican claims that “you need an account that is yours so the government can’t legislate it away” when the only government that has EVER threatened to do that is THEM. Indeed, the biggest threat to SS isnt the solvency of the system – It is George Bush.

  9. a different chris
    February 18th, 2005 at 08:20 | #9

    This sentence is rather unfortunate. However, I may use it to scare the kids if ever the adc household cash flow looks less than optimal:

    For example, given credit constraints, it’s generally desirable to increase the consumption of the young
    :D

    (No, I don’t have anything constructive to contribute except a hearty Attaboy! or whatever the Aussie eqivalent would be).

  10. John Quiggin
    February 18th, 2005 at 09:17 | #10

    Aargh! The blog revolution devours its children :-)

  11. Ian Whitchurch
    February 19th, 2005 at 18:04 | #11

    Huh ?

    Rationalisable Expectations … Econometrica, 1984, pp1040 or so.

    Case in point, right here right now – the speculative bubble in Karoon Gas shares.

    Market participants are assuming that everyone else knows SOmething Important about Karoon that makes them worth $1.40 a share, rather than the thirty cents they deserve.,

    In reality, the information available to the market is mostly bad (USGS note “intermittent quartz overgrowths” in the reservoir sands, and three leases have just been given up in the Browse) … but market participants arent bothering to find out, as that is costly.

    But they do rationalise ‘if it wasnt really valuable, if really good news isnt about to come out, then the price wouldnt have run so high or so hard’.

    Ian Whitchurch

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