>From: "Charles Brown" <[EMAIL PROTECTED]> > http://www.cepr.net/stock_market_bubble.htm > > > > > > >The Costs of the Stock Market Bubble > > > By Dean Baker > > > >Executive Summary > > >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. > > > > >_______________________________________________ >Crashlist resources: http://website.lineone.net/~resource_base >To change your options or unsubscribe go to: >http://lists.wwpublish.com/mailman/listinfo/crashlist > _______________________________________________________ KOMINFORM P.O. Box 66 00841 Helsinki - Finland +358-40-7177941, fax +358-9-7591081 e-mail [EMAIL PROTECTED] http://www.kominf.pp.fi _______________________________________________________ Kominform list for general information. Subscribe/unsubscribe messages to [EMAIL PROTECTED] Anti-Imperialism list for anti-imperialist news. Subscribe/unsubscribe messages: [EMAIL PROTECTED] [EMAIL PROTECTED] _______________________________________________________
