Andrew Samwick summarized the blog reaction to Krugman’s latest NYTimes oped the same even that the oped ran. Andrew was kind to my musing about the Solow growth model after he offerred his insights, which I do agree with:
The critical assumption in the Baker/Krugman example is that the dividend yield doesn’t rise above a number like 3 percent, forcing the capital gains to cover the other 3.5 percent and be reinvested in the corporate sector. What if the payout ratio increased dramatically, so that capital gains accounted for only the same 1.9 percent return that matched the growth rate in profits and the economy as a whole? The inconsistency goes away, as the P/E ratio is stable…But is a high payout ratio (e.g., 50% larger than what Krugman is positing) so unrealistic? I don’t believe that economists as yet have a solid answer to this question, largely because they don’t have robust models of what determines the dividend payout ratio. The most frequent answer that I have gotten when shopping this question around to better macroeconomists than I has been that the partition between capital gains and dividends is indeterminate in models used to study long-term growth.
To explain the analogy to the Glassman-Hastert (DOW 36,000) two-step, consider two simple equations. The first is V = C/(r – g) where V is firm value, C is cash flow, g is the stready state growth rate of cash flows, and r is the cost of capital.
Glassman-Hastert had assumed faster growth would mean higher cash flows and firm value without considering the cost of growth, which is the second equation, C = P – g*A where P is profits and A represents tangible assets.
To extend Andrew’s suggestion, let’s make two simplying assumptions. The first is the premise that a firm might set its payout ratio so that all cash flows are remitted to shareholders with retained earnings barely covering the new investment in tangible assets necessary to finance an exogenous growth rate. The second assumption is that P/A just happens to be equal to the cost of capital, which would imply V = A (in other words, no intangible assets).
In this highly restrictive and admittedly simplified model, the payout ratio = C/P = 1 – g/r. As an illustration, let’s assume that the cost of capital (r) is 8% and consider a fall in the growth rate from g = 4% to g = 2%. Under the higher growth rate, the payout ratio is 50% and the dividend yield (C/V) is only 4%. But under the lower growth rate, the payout ratio is 75% and the dividend yield rises to 6%.
Of course, this inverse relationship between the exogenous growth rate and the endogenous payout ratio is based on premises of other variables being exogenous, which I admit is an incomplete modeling approach at best. Of course, the Club for Growth crowd rarely presents a complete or coherent even though Solow’s model is now half a century old. The key change suggested by the Social Security Trustee’s model, which the Club for Growth apparently does not get, is a reduction in the population growth rate and not a reduction in the productivity growth rate. And the Solow model suggests capital-deepening if population growth falls relative to the savings rate. Of course, the Club for Growth crowd celebrates the Reagan-Bush43 fiscal policies that may have reduced the savings rate claiming that these policies somehow promote more growth.
I’m not surprised that neither the Club for Growth or Glassman-Hastert pointed out what a very smart conservative economist noted. But then Andrew subscribes neither to their Social Security is bankrupt claim nor to their free lunch claim. Speaking of the latter, I still think Robert Barro got it right five years ago. If households are rational and maximizing utility as a function of expected returns and risk, they know the Trust Fund invests their Social Security funds in government bonds so adjust their 401(K) portfolios between stocks v. bonds so as to achieve the optimal; mix of expected return and risk. If we give them control of their Trust Fund assets, the Barro view would hold that they would place these funds into the same assets that the Trust Fund does. So how is that going to increase portfolio return. If one goes back half a century and read the various papers by Markowitz and Tobin, one might conclude as Barro does that there is nothing to this free lunch claim – at least the way the Club for Growth crowd puts it.