Asset Returns and Economic Growth

It is difficult to see how real U.S. GDP growth can be as rapid in the next half-century as it has been in the last. The baby boom is long past, and no similar explosion of fertility to boost the rate of labor force growth from natural increase has occurred since or is on the horizon. The modern feminist revolution is two generations old: no reservoir of potential female labor remains to be added to the paid labor force. Immigration will doubtless continue—the United States is likely still to have only one-twentieth of the world's population late in this century and to remain vastly richer than the world on average—but can immigration proceed rapidly enough to make the labor force grow as fast in the next fifty years as it did in the past fifty? Productivity growth, the other possible source of faster GDP growth, is a wild card: although we find very attractive the arguments of Robert Gordon for rapid future productivity growth,¹ his is not the consensus view; this is shown most strikingly by the pessimistic projection of the Social Security trustees that very long run labor productivity growth will average 1.6 percent a year.²

A slowing of the rate of real economic growth raises challenges for the financing of pay-as-you-go social insurance systems that rely on a rapidly expanding economy to provide generous benefits for the elderly at relatively low tax rates on the young. An alternative way of financing such systems is to prefund them, and for that reason projections of future rates of return on capital play an important role in today's economic policy debates. The solutions to many policy issues depend heavily on whether historical real rates of return—especially the 6.5 percent or so annual average realized rate of return on equities—are likely to persist: the higher are likely future rates of return, the more attractive become policies that, at the margin, shift some additional portion of the burden of financing social insurance onto the present and the near future, thus giving workers' contributions the power to compound over time.

We believe that the argument for prefunding—that slowing economic growth creates a presumption that the burden of financing social insurance should be shifted back in time toward the present—is much shakier than many economists recognize.³ It is our belief that if forecasts of slower real GDP growth come to pass, then it is highly likely that future real returns to capital will likewise be significantly below past historical averages. In our view the links between asset returns and economic growth are strong: the algebra of capital accumulation and the production function and the standard macrobehavioral analytical models that economists use as their finger exercises suggest this; arithmetic suggests this as well, for we cannot see any easy way to reconcile current real bond, stock dividend, and stock earnings yields with the twin assumptions that asset markets are making rational forecasts and that rationally expected real rates of return will be as high in the future as they have been in the past half-century.

Our basic argument is very simple. Consider a simple chart of the supply and demand for capital in generational perspective (figure 1). The supply of capital—the amount of investable assets accumulated by savers— presumably follows a standard (if probably steeply sloped) supply curve,⁴ with relative quantities of total saving and thus of capital plotted on the horizontal axis, and the price of capital—that is, its rate of return—on the vertical axis. The demand for capital by businesses will, of course, depend on the rate of return demanded by the savers who commit their capital to businesses: the higher this required rate of return, the lower will be business demand for capital—and the more eager will businesses be to substitute labor for capital in production. The demand for capital by businesses depends on many other factors as well, from which we single out two: