The disconnect between per-capita real GDP growth and expected investment returns

As the equity markets have imploded over the last year, a lot of explanations for what’s happened have been popping up. Most of these involve pointing fingers at a variety of problems tied to debt – sub-prime and otherwise. However, I think there is a far more fundamental problem that has long existed that not only has very little to do with the now “common” explanations for what has transpired, but also points towards a collective irrationality that has existed for many decades. The basis of this fundamental problem is a disconnect between per-capita real GDP growth, and expected investment returns.

For those that might need a refresher, Real GDP is a macroeconomic measure of the size of an economy adjusted for price changes and inflation. It measures in constant prices the output of final goods and services and incomes within an economy. In other words, it’s an aggregate measure of what an economy produces, or if you prefer the income a defined group of people (typically a country) earn over a given time frame (typically a year).

Economists pay a lot of attention to the growth rate applied to Real GDP, which indicates how much our collective wealth is increasing. But the more interesting measure here is the per-capita growth rate of Real GDP, which is an indicator of how much wealthier each of us get, if – and this is crucial – the gains were distributed “equally” across the population.

So here’s the thing that strikes me as odd. If you run the numbers for a variety of “developed” economies (like the U.S., Canada, etc.) for the last 20 years, the average is around 2% – how much wealthier, theoretically, each is could have been each year, again if the gains were distributed amongst the population.

With that in mind, think about the investment returns people have achieved, and expect into the future. Over the last few decades real returns have been well, well above 2%, and even today people continue to forecast 4% + real returns, on an annual basis.

So taking a REALLY long-term perspective, these expectations are certainly impossible – if your individual wealth increases faster than the per-capita GDP growth rate, eventually you will control all of the wealth in the world. But taking a shorter term perspective, how many people can reasonably enjoy the benefits of their individual wealth growing at a rate in excess of the per-capita GDP growth rate?

Now one answer people might give is that this is just the rich getting richer, while the poor get poorer – and there is certainly an argument to be made here. But let’s throw out a couple of specific pieces of data to further bring the issue into context.

Everybody that works in Canada contributes to the CPP – our social security system. This plan expects to keep piling up a portion of these contributions, and investing them in a fund that earns a 4.1% real return annually. In turn, every single worker in Canada is, in effect, depending on their “individual” share of the wealth growing at 4.1%  a year. But if you go back to the per-capita GDP growth rate, in Canada it’s been 2.25% the for the last 45 years or so, and 1.7% for the last 20.

So… the social security system that supports virtually all Canadians is depending on earning investment returns several times higher than the per-capita growth rate of the Canadian economy, and they expect this to happen for at LEAST the next 75 years. Sounds kind of weird when you think about it that way, doesn’t it?

Tagged as: economy, investing, irrational expectations, returns, stock market