A lan Greenspan is known for his guarded pronouncements, carefully crafted in order to soothe financial markets. But in his semiannual testimony before the House Banking Committee this February, Greenspan did not mince words. He pointedly explained why stock prices should only rise as fast as disposable income. This would imply a growth rate for stock prices of just 5 percent annually. For investors who have come to expect double-digit returns, this is quite a letdown.
On closer inspection, the situation looks even worse. Currently, dividend payouts are only slightly higher than 1 percent. So if Greenspan is right, the total return from holding stock (dividends plus capital gains) will be around 6 percent, approximately the same yield offered by perfectly safe government bonds. It makes no sense to hold risky stock if the return is no better than on government bonds.
This year some air has already come out of the inflated market. The NASDAQ is down about 30 percent from its peak, and at this writing, the broad market has declined about 8 percent. But for stock returns to be more in line with returns on bonds and other assets, stock prices will have to plummet further. A plunge in stock prices raises the dividend yield. (For instance, if a stock pays a $1 dividend when its price is $100 per share, then its dividend yield is 1 percent. If the stock price falls to $50 per share and it still pays a $1 dividend, then the dividend yield is 2 percent.) Historically, the price-to-earnings ratio has been under 15 to 1, implying a dividend yield of over 6 percent. At present, this ratio is slightly under 30 to 1. So the market could easily fall by another 50 percent.
A stock crash of this magnitude would have a huge impact on the economy, most obviously on the demand side. A 50 percent decline in the market would destroy almost $10 trillion in paper wealth. When stocks go up, people feel richer and spend more. The standard rule of thumb is that every dollar of stock market wealth increases annual consumption by three to four cents. This means a loss of wealth of $10 trillion would reduce annual consumption expenditures by approximately $350 billion, an amount just under 4 percent of GDP. If this decline happened quickly, it would virtually guarantee a steep recession.
There could also be a negative demand-side impact from government, depending on how it responds. Current budget projections assume that the government continues to collect more than $90 billion a year in capital gains taxes. If the market were to plunge, capital gains revenue would fall close to zero, leaving a cumulative revenue shortfall of around $900 billion over the next decade, in addition to the general revenue lost because of an economic downturn. Under such circumstances, it would be reasonable for the government to run large deficits. But given the general bipartisan commitment to balanced budgets, government could be forced to cut spending or raise taxes at a time when the economy is already suffering from inadequate demand.
The obstacles to Keynesian demand-side remedies are mainly political. If the Federal Reserve Board eases interest rates and the federal government runs temporary large deficits, the demand-side impact of a stock market crash can be limited. However, the supply side of the equation may be harder to remedy.
For one thing, a plunging stock market would lead to cutbacks in investment. Although in the aggregate, corporations have bought back more shares than they have issued, some firms, especially new ones, issue stock to raise money for investment. The recent "correction" in technology stocks has already dampened the IPO boom. A more general plunge in the stock market will make it considerably more difficult for Internet start-ups, biotech companies, or industry in general to finance new investment.
There are three more subtle mechanisms through which a stock bubble, followed by a crash, can affect the supply side of the economy, notably the supply of labor and capital. We might term these mechanisms the "dumb worker effect," the "welfare mother effect," and the "spoiled child effect."
The dumb-worker effect is derived from an important strand of economic literature that explains booms and busts as the result of workers misperceiving their real wages. This view is associated with Nobel laureates Milton Friedman and Robert Lucas. It holds that workers often demand too much pay, or too little, because they misunderstand inflation. For instance, if workers thought that the rate of inflation was only 2 percent, but it ended up being 4 percent, then they could be tricked into working for a lower real wage than they otherwise would have accepted. Conversely, they may demand more than the firm can afford to pay them because they think inflation is higher than it really is. These misallocations of wages then lead to business cycles of boom and bust.
The dumb-worker hypothesis is relevant to a stock market crash since many workers now expect a growing portion of their compensation in stock options--and they may be disappointed. A recent Federal Reserve Board survey found that over a third of the firms surveyed included stock options in the compensation package for at least some workers. Disproportionately, this was the case with large and rapidly growing firms and with higher-paid workers. About one-third of the managers and professionals in the surveyed firms received part of their compensation in stock options. The study estimated that the "execution price" of the options (effectively the market price at the time they are issued) was equal to 1.6 percent of total labor compensation in 1998. But the realized value of the capital gains on the options cashed out in 1998 was 9.2 percent of labor compensation. Both figures are more than three times the values estimated for 1994.
If the stock market were to plunge by 50 percent, most of these options would be worthless. But how would workers respond? Economists Friedman and Lucas had workers entering or leaving jobs based on very small changes in the perceived value of the real wage (the inflation rate rarely changes by more than 1 or 2 percentage points in a year). The impact of these options becoming worthless would be immense since many workers expect to receive 20 percent or more of their compensation through cashing in stock options.
How many computer engineers, say, at Microsoft, would be willing to stay at their jobs for their salaries alone? Companies might attempt to offset the lost value of stock options with higher base pay, but this would have to come at the expense of profits at a time of general recession and depressed sales. We just don't know the effect of this squeeze.
Consider also the effect of stock windfalls on the incentive to work. Call it the welfare mother effect. Abnormally high stock returns in recent years have allowed many workers to accumulate far more wealth than they expected. Prior to the 1996 federal Welfare Reform Act, there was a major national policy debate over the disincentives to work that resulted from welfare payments averaging less than $6,000 a year. The stock run-up of the past five years has allowed workers to accumulate hundreds of thousands of dollars in windfall returns. This windfall, unless it is reversed by a crash, will allow many people to retire several years earlier than they otherwise might have.
The absolute number of such workers is relatively small because stock holding is still highly concentrated. In the most recent Federal Reserve Board survey, just under half of all workers held any stock at all, including through mutual funds and 401(k) plans. The median value of stockholdings among this group was only $28,000, not an amount that could accelerate retirement by too much. But highly paid workers and older workers have larger holdings. Those workers who do retire early based on their current stock holdings would of course find life more arduous after a crash and would likely have difficulty returning to their old jobs.
Another supply-side effect is the spoiled-child effect. Based on the recent market run-up, many people have come to believe that they have a right to expect 15-25 percent annual stock returns. One reason that so much money continued to flow into an obviously overvalued stock market was that many investors were contemptuous of the 6-7 percent returns available on bonds or other safe investments. Once it becomes clear that the stock market will not produce these returns in the future, some investors may move their money into bonds, but others will pursue even more speculative investments.
Inevitably, many investors will lose much of their savings due to bad luck or outright fraud. On the one hand, such a fate might be well-deserved for the greedily ignorant. But from the standpoint of the economy as a whole, it could mean not only a huge drop in purchasing power but a massive waste of resources. Today, Internet start-ups with no idea of how to make a profit are able to raise billions in financial markets. Meanwhile, many industrial firms with real products and customers are being starved for capital.
This sort of crowding out of productive investment is every bit as harmful when carried on through financial market euphoria as when it occurs via huge government deficits. As long as resources that could be invested productively are instead directed to wasteful ventures, the whole economy will pay a price. It took the New Deal and World War II before the economy recovered from the last great crash. Have we learned enough since then to avoid or mitigate another crash--or have we forgotten what we learned? ¤
Dean Baker is the co-director of the Center for Economic and Policy Research and the author of the Economic Reporting Review (www.fair.org), a weekly online commentary on the economic reporting in The New York Times and The Washington Post.
