The Costs of the Stock Market Bubble
By Dean Baker
Most economists who have examined the run-up in stock prices over the last four years have concluded that it is experiencing a bubble which cannot be sustained. The ratio of stock prices to corporate earnings peaked earlier this year at more than thirty to one. This ratio is more than twice the historic average, which has been approximately 14.5 to 1 over the last fifty years. The record high price -to-earnings ratio appears even less justifiable given that most mid-term projections show very weak profit growth. For example, the Congressional Budget Office (CBO) projects that profits will actually be 10 percent lower in real terms in 2010 than at present.
If this CBO projection is anywhere close to being accurate, then it implies that the stock market is hugely over-valued. Using a variety of assumptions on future profit growth and long-term equity premiums for stocks relative to government bonds, this paper shows the extent of the over-valuation to be in the range of $8-13 trillion. An over-valuation in the stock market of this magnitude is going to have very serious consequences for the rest of the economy. This paper examines some of the likely effects of this over-valuation.
The most obvious effect of the stock market bubble has been the decline in national savings due to the wealth effect. It is generally accepted that every dollar of wealth in the stock market generates 3-4 cents of additional consumption. According to standard economic theory, this additional consumption crowds out investment and net exports in exactly the same way as a government budget deficit would. A simple extrapolation implies that the consumption induced by the bubble has crowded out between $460 -$960 billion of both investment and net exports over the last six years. At present, the additional consumption attributable to the bubble is having the same negative effect on national savings as a $320 billion budget deficit.
According to standard economic theory, this loss of savings has reduced the amount of investment in the United States. More importantly, it has been a major cause of our trade deficit, which in turn has led to large U.S. borrowings from the rest of world. At present, the United States is borrowing close to $450 billion annually from abroad. This is money that otherwise could have gone to support investment in the developing world. This implies that people in developing nations are paying a high price because of the stock bubble in the United States.
A second potentially large cost associated with the bubble is the effect of misperceptions of the value of the real wage. There are two ways in which the bubble can cause misperceptions. Many higher paid workers, particularly in the high tech sector, are receiving a substantial portion of their compensation in the form of stock options. In a rapidly rising stock market these options have a high value. If workers include the anticipated value of stock options in their wage expectations, then they will be expecting a much higher real wage than firms will be able to provide when the market corrects. Estimates from a recent Federal Reserve Board study imply that the stock market run-up may have added 2.0 percentage points to labor compensation over the period from 1994 to 1998.
The second way in which the bubble can lead to a misperception of the real wage is through its impact on the value of the dollar. The huge trade deficit implies that the dollar is over-valued by between 20-30 percent. This has the effect of raising the real wage as long as the high dollar holds down the price of imports. However, when the dollar eventually corrects, this effect will be seen in reverse, as the falling dollar will lead to higher import prices and a lower real wage. The decline in the dollar could lower the value of the real wage by between 1.5and 2.2 percent.
The potential impact of these two effects is quite large. The standard theory of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) was based on the view that workers came to misperceive the true real wage in a time of rising inflation. According to this theory, if they came to expect a real wage that was too high, it was necessary to have an unemployment rate that was above the NAIRU for a period of time in order to force down expectations. The standard rule of thumb is that to lower expectations by 0.5 percentage points, it was necessary to have an unemployment rate that is 1.0 percentage point above the NAIRU for a year. Combining the impact of stock options and the over-valued dollar, real wage expectations may be more than 3.0 percent higher than what can be sustained after the adjustment in the dollar and the stock market. According to the standard NAIRU theory, this would imply a need to have an unemployment rate that is 1 percentage point above the NAIRU for six years (or six percentage points higher for one year), in order to get wage expectations back in line with the economy's potential. While there are very good reasons for questioning the basic tenets of the NAIRU view, economists who accept this theory should be very concerned about these implications of an over-valued in the stock market.
Another cost of the bubble is the amount of mis-investment that may have been caused, since not all shares were equally over-valued. If many of the Internet stocks were significantly over-valued, as now appears to have been the case, it means that tens, or possible hundreds, of billions of dollars that could have been invested productively were instead wasted in poorly conceived ventures. This mis-investment probably came at the expense of many firms in more traditional industries who have found it difficult to raise capital in recent years. This effect was exacerbated by the run-up in the dollar which made it more difficult for many of these firms to compete with foreign firms. It will only be possible to estimate the quantity of this mis-allocated investment after the market has corrected, but it is likely that it has been large.
The bubble also has led to a substantial redistribution of wealth and income, both within and between generations. Within generations, those who were directly employed in the bubble industries were best situated to gain. However, many others ended up being losers as a direct result of the former group's gains. The most visible manifestation of this effect is the soaring housing prices in places like Silicon Valley and Seattle, where many of the high-tech firms are headquartered. Those without big stakes in these firms had to cope with the run-up in housing prices driven by those who had substantial stock holdings.
The generational effect is likely to be quite large. A generation of workers is being allowed to sell their stock at inflated prices to younger workers, who will receive an extraordinarily bad return on their investments. Reasonable assumptions about the size of this effect show that for middle income workers, the losses from buying stock at inflated values are likely to dwarf any costs incurred from higher Social Security taxes at any point in the foreseeable future. For example, a worker who began placing $1000 a year in the market beginning in 1995 would lose between $4,000 and $17,000 by 2010 as a result of the bubble. The worst scenario for this worker is a gradual adjustment by 2010 to the market's proper value. A quick crash would significantly reduce these losses. In spite of the size of the prospective loses facing younger workers, the stock market bubble has received virtually no attention from the economists and political figures who have expressed concern about the potential generational burdens created by Social Security or Medicare.
The bubble is also likely to have a large effect on the labor force participation rates of older workers who are able to sell their stocks at inflated prices. Many economists have raised concerns that Social Security benefits encourage workers to leave the labor force earlier than they might have otherwise. For many workers, the over-valuation of the stock market will provide much more financial support for an early retirement than Social Security.
A stock market correction could have many other effects which are difficult to predict. For example, it may cause investors to be excessively cautious about investing in the stock market, thereby raising the cost of capital. This was an important outcome of the 1929 crash. It may also cause some investors to seek out even more high-risk ventures as they look elsewhere to get the double digit returns that were available in the stock market between 1995 and 1999. It is also likely that a stock market correction will lead to a sea of litigation as investors try to recover some of their losses from corporations that provided misleading information or brokers who gave bad advice. The effects could be exacerbated if the Federal Reserve follows the wrong policy in the wake of a correction, for example if it raised interest rates to support the value of the dollar.
The full implications of a stock market correction will be impossible to determine in advance. But when prices get as far out of line as they did in the recent stock market run-up, it is inevitable that there will be serious consequences. The economics profession has been extraordinarily negligent in not paying more attention to this problem.
If the stock market is significantly over-valued, then the over-pricing will impose large costs on the economy. These costs will both affect aggregate growth and distribution, with the distributional effects having a strong generational dimension. While it will be necessary to further develop estimates of the specific costs noted here, relatively simple calculations suggest that they are quite large compared to other issues that have occupied the attention of economists, as well as policy-makers and journalists.
Specifically, the consumption boom caused by the wealth effect has essentially offset the increase in national savings that resulted from the transformation of 1980s budget deficits to the present surpluses. This decline in national savings would be expected to lead to a decline in both investment and net exports. Standard assumptions about the impact of consumption on investment and net exports suggest that the United States is losing close to $200 billion a year in both investment and net exports because of the stock market bubble. The reduction in net exports amounts to capital that the United States is borrowing from the rest of the world. This is capital that could otherwise be invested in the economies of developing nations. It also is causing the United States to build up foreign debt at an unprecedented rate.
The stock market boom has also created a potential basis for future inflationary pressures through two channels. First, through stock options the boom has in effect allowed a portion of workers' wages to be paid out of the excessive capital gains in recent years. When the bubble corrects, these capital gains will no longer be available. Similarly, the over-valued dollar, which has accompanied the stock boom, has given workers the opportunity to buy imports at prices that are temporarily depressed. When the dollar falls back to a level that is more sustainable, the prices of imports will rise significantly. Together these two effects can easily add more than 3.0 percentage points to the underlying rate of inflation. According to standard views of the NAIRU, it would require 6 years in which the unemployment rate was a full percentage point above the NAIRU to squeeze this inflation out of the economy. Although the NAIRU view should be treated with skepticism, economists who accept this theory in other contexts must recognize the costs implications of a collapse of a stock market bubble and the dollar within the framework of their theory.
The stock market bubble also leads to substantial redistributions both within and between generations. The transfer from younger generations of workers investing in an over-valued market to the older workers cashing out; are probably larger than the potential increase in payroll taxes associated with a shortfall in the Social Security trust fund. Research on the impact of increasing Social Security benefits on labor force participation among older workers suggests that this transfer is also likely to have a significant effect on the labor supply of older workers.
There are a wide variety of other potential negative consequences from the current over-valuation in the market. As basic economic theory and common sense would suggest, when a major market diverges in a large way from its proper value, it creates significant economic distortions. An over-valuation in the stock market, which could be more than $13 trillion, should be a cause for concern. The longer it persists, the greater the costs become. For whatever reason, economists have so far largely neglected this topic.
Center for Economic Policy Research