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. 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.