Martin S. Feldstein
George F. Baker Professor of Economics
Harvard University
Cambridge, MA 02138

Mr. Dean Baker
Mr. Mark Weisbrot
Preamble Center
1737 21st Street, N.W.
Washington, D.C. 20009

Dear Mr. Baker and Mr. Weisbrot:

I am writing to comment on the correspondence and press releases that you have been sending to me and many others about the possible return on equity investments.

Your basic point is that "the 6.5-7.0 percent real returns assumed by advocates of investing in the stock market are inconsistent with the 1.5 percentage growth rate for the economy and profits assumed by the Social Security Trustees" (News from Preamble, February 22, 1999).

As a matter of basic economics, this is simply wrong. There is no necessary relation between an economy’s growth rate and the rate of return earned on capital in general and equity capital in particular. Neither economic theory nor historic experience points to your conclusion.

The US economy has had a much higher rate of return on capital for the past 75 years than our rate of growth. Real economic growth was minimal for centuries before the industrial revolution, but capital was still productive and rates of return were positive.

A basic text book example makes the same point. Consider a simple agricultural economy that does not grow at all. Each generation is the same size as the previous generation. Assume also that there is no growth of productivity, i.e., no technological improvement. So real wages remain the same year after year. The capital stock also remains the same. But capital is nevertheless productive in this no-growth economy. The plows and other equipment make the farm workers more productive than they would otherwise be. That capital, therefore, earns a rate of return for its owners. Note that the amount of profits do not grow in that economy.

So even if we have slow growth of population and wages in the future, we can still have a high rate of return on capital. The amount of profits will grow at about the same rate as the rest of the incomes in the economy, but the amount of profit per unit of capital is the profit rate and that profit rate can be substantially higher than the rate of growth of the amount of income and capital in an economy.

I think it would be good if you stopped confusing the discussion with your simple mistake.


Martin Feldstein