July 17, 2002
For the moment, let's assume that the stock market is not predicting economic events but is discounting uncertainty about misfeasance and inaccurate accounting. Indeed, my economy indicators currently reflect no fears that can justify the plunging valuations of American enterprises.
Even if the economic recovery appears to be progressing, can the slumping market push the economy back into recession. More importantly, will this slumping market mean serious economic problems ahead.
In a book about stock market behavior during the Great Depression, John Kenneth Galbraith argued that the cause ran from stock speculation and subsequent slump to lost jobs and economic despair. Few economists would take the message that far, but Galbraith outlined a process that certainly has merit.
In his view, speculation led to misallocated resources. So much money was being used to support enterprise values that not enough was left for enterprise building. Like all scarcities, this scarcity of resources for real enterprise development was apparent in the price of broker loans and other short term debt instruments.
Of course, the crash was inevitable, as the market value growth was at the expense of the growth of enterprise value. By the time the bubble burst and money was released from speculation, no one wanted funds for enterprise development. The crash took away the need to grow capacity.
I used to explain this process in my classes to indicate that the stock market could cause (not just reflect or predict) economic weakness.
Are there signs that resources have become too expensive for enterprise development? The collapse of venture capital investment certainly is spectacular (from a peak of $90 billion in investment capital in 2000 to less than $25 billion currently).
Of greater concern is the flight to quality treasury bonds and the flight from low quality corporate credits. The junk bond market suffered its largest single monthly loss ever in June even as Treasury bonds performed strong gains. However, the fallen angels from investment grade to junk created most of these problems. Default rates actually dipped modestly in the last few months.
Certainly, short term interest rates did not have the surge that broker loans did during the early days of the Great Depression. For quality credits, interest rates are at historical lows and funding is available.
Two major channels by which stock market declines flow to real economic activity have been given a great deal of attention. One, the wealth effect, shows how a reduction in the market value of stock ownership eventually will lower the growth of household consumption. When the markets were exploding, the wealth effect took several years to surface. Perhaps its impact will be as muted on the downside as those 401K balances continue to implode.
Two, the loss of enterprise value discourages capital spending committees from spending. If a dollar of investment creates less than a dollar of market value, then that dollar could be better spent for the investor either by returning it in the form of dividends or, because of tax treatments, spending the money to buy back stock rather than build the enterprise.
I already have shaved consumer spending for the end of this year because of the stock market slump, but I still have spending gains. I also have reduced my estimates of investment. However, capital spending now is so low, and technology remains so effective, that I cannot see a further major falloff in capital expenditures.
In short, the Galbraithian world is not about to happen, but the wealth effect and lowered enterprise valuations will shave a percentage point from growth late this year and early in 2003. I now have 2.3 percent growth for this year and 3.5 percent gains for next year.
Of course, the great risk is that I under-estimate the degree of collapse in stock values. A forward ratio of stock prices to earnings of 23 for the Standard and Poor's 500 stocks is historically high, until the historically low interest rates are also considered.
Furthermore, when more terrorist attacks were expected and when a recession was firmly in place, stock values soon stabilized at higher values than currently persist. Were the corporate lies so great that they even garner more weight than terrorist fear. Perhaps, but I think not.
Finally, some economists are worried that the market turmoil will cause international investors to flee our markets. This will lower prices and cause more to flee, leading to a downward spiral in prices.
If the dollar already was undervalued, then such declines could weaken the world economy, causing substantial economic pain worldwide. With the dollar overvalued, some decline toward more sustainable dollar values are beneficial to the world. Our improved exports should overcome the reductions caused by falling market values.
Therefore, I don't see as much economic weakness ahead as some others are beginning to spot. But I sure wish the President was as effective in restoring confidence to investors as he was to a terrorist worried nation.