SYNOPSIS: Putting Social Security in the market is too dangerous

The debate over Social Security reform is not exactly noted for witty repartee. But one much-repeated joke says that the pace of reform will determine the future of stock prices: the big crash will come only once a few trillion dollars of the retirement fund have been put into the market.

Gallows humor aside, it's a real issue. Historically, investors who bought stocks have earned much higher returns than the Social Security Administration, which buys only government bonds. Inevitably, then, many would-be saviors of Social Security believe that stocks are the answer to the system's problems. But if you use conventional ideas about valuation, today's stock prices look very high. So would investing in stocks now be a classic case of bad timing?

This question has suddenly become much more relevant, now that George W. Bush has announced his Social Security plan. He doesn't want the trust fund itself to buy stocks. But he does want to let workers put some of their contributions into individual retirement accounts, which could be invested in stocks. And he justifies this proposal by pointing to the high returns that stock market investors have historically earned, and comparing these returns with the "dismal" returns of the Social Security Administration. The higher returns people can get by investing in stocks will, he argues, let him scale back guaranteed benefits without reducing actual retirement income.

If you think that stocks are currently overpriced, this proposal sounds like a recipe for disaster: it will encourage workers to buy stocks at exactly the wrong time -- eventually leading to an even worse Social Security crisis, as the government finds itself under intense pressure to bail out the baby boomers.

But optimists counter that even though stocks look overpriced by conventional measures -- the price-earnings ratio of the average S.&P. 500 stock is more than twice as high as the historical average -- those conventional measures are misleading. The sensible argument on behalf of current stock valuations is that historically stocks have been underpriced, because investors have been far too cautious.

Economists who make this argument point to the same statistics cited by Mr. Bush: the fact that stocks have consistently yielded a much higher rate of return than bonds. Why this "equity premium" persisted so long remains a puzzle: why didn't investors long ago rush into stocks, driving their prices up and their rate of return down? But anyway, the puzzle is now history: in the 1990's investors did rush into stocks. What the optimists believe is that this rush corrected an error rather than creating one, that the rise of the stock market in recent years reflects not the rise of irrational exuberance but the decline of irrational risk aversion.

I have my doubts about this story. But suppose that it is right, and that current stock valuations are in fact reasonable. Does this then validate Mr. Bush's plan? Alas, no. You see, those high returns cited by Mr. Bush -- the returns that are supposed to produce huge gains for workers free to make their own investment decisions -- are what stock investors got during an era in which people were very leery of stocks, and hence prices were low compared with earnings. Now that people are no longer so nervous, prices are much higher compared with earnings -- and the higher the price you pay for an asset, the lower the rate of return on your investment. (Duh.) So the rate of return on stock investments made now will probably be much lower than the returns people got in the past. (Remember, this is the optimistic scenario, which claims that current values are reasonable -- if they aren't, the return will be even lower.) And that means that the proposition that individual investors can expect to do a lot better than the Social Security Administration -- so much better that we can wave away concerns about increased risk -- evaporates.

So Mr. Bush can defend himself against the charge of bad timing by arguing that stocks are not overvalued, that their high prices are justified because people no longer demand traditionally high rates of return. But how can he then assume that people will nonetheless get those traditional high returns -- and use that assumption as the basis for a huge policy initiative?

I just don't get it. But then, I'm not running for president.

Originally published in The New York Times, 5.17.00