Why Real Rates of Return Will Fall

Earlier this month the Wall Street Journal published an article entitled “Private Accounts Can Save Social Security,” authored by Martin Feldstein, former chairman of President Reagan’s Council of Economic Advisors and a member of the Wall Street Journal’s board of contributors.

In this article, Feldstein made the following assertion: “With a 3% payroll deduction, someone with $50,000 of real annual earnings during his working years could accumulate enough to fund an annual payout of about $22,000 after age 67, essentially doubling the current Social Security benefit. That assumes a real rate of return of 5.5%, less than the historic average return on a balanced portfolio of stock and bond mutual funds.”

It is pretty easy to paint rosy scenarios when you assume a real rate of return of 5.5%. But “the historic average return” Mr. Feldstein alludes to presumably includes the last 40 years or so, a period during which total debt in the U.S. has doubled five times, and now stands at over 350% of GDP.

America’s credit market debt, which includes all consumer, commercial, and government debt, totals over $50 trillion dollars. And the reason this debt has not already crippled the U.S. economy is because the cost of money to most significant debtors is below the rate of inflation. The rate of interest that borrowers pay today – whether they are the U.S. government or people signing 30 year home mortgages – is basically zero.

How then, can a pool of savers as large as America’s entire retired population expect to draw 5.5% on their investments, after inflation, for the next several decades? The reason these returns existed in the past was because we were experiencing debt fueled, unsustainable rates of rapid economic growth. Now that debt levels have reached their ceiling – even with rates at virtually zero, total debt is not increasing any more – growth must slow because less new cash is being loaned to borrowers and injected into the economy. What part of this does Mr. Feldstein fail to understand?

What is particularly irksome, beyond Feldstein’s blithe assertion that a real rate of return of 5.5% is something we can simply take as a given, is that his pronouncement provides cover to the public employee pension fund “experts” who themselves claim a real rate of return of 4.75% is sustainable for decades over decades.

Ultimately, what Feldstein is doing suggests one of two possibilities. Either Feldstein is a tool of the Wall Street cabal that conned an entire nation into drowning themselves in debt, which would mean he is required to maintain the fictional expectation of high returns forever because to change his tune now would be to admit it was all a big con, or he actually thinks the citizens of this nation can continue to pile on debt.

An excellent recent post by Chris Martenson entitled “The Failure of Fed Policy, Why Growth is Dead,” contains information that ought to pour cold water on the notion Americans can continue to grow their debt burden. In his post there is a graphic that shows when, starting in 1970, total credit debt in the U.S. doubled: 1977, 1983, 1989, 1999, and 2007. And since 2007, total credit debt has remained relatively stable, despite the fact that since 2007 the composition of the debt is shifting from the private sector to the government.

For Martin Feldstein, or anyone claiming to speak for a public employee pension fund, or anyone else for that matter, to opine on what real rate of return may be expected on assets totaling trillions of dollars, they must address the fact that total debt in the U.S. is now about 350% of our GDP. For Feldstein to ignore this fundamental variable undermines his credibility, the credibility of the Wall Street Journal, and calls into question any claim they may have to being advocates of financially realistic policies.

If Mr. Feldstein would care to suggest for me an investment portfolio that I could truly rely on to deliver a 5.5% return, after inflation, for the rest of my days, I would sell everything tomorrow to put it there. Rarely has the old disclaimer “past performance is no indicator of future results” been so apt.