The Wealth Effect Faces Hard Times

A stock-market bubble exists when the value of stocks has more impact on the economy than the economy has on the value of stocks. Hot sector after hot sector in the U.S stock market is bursting, starting with the Internet bubble, which has already burst, and continuing with the information-technology bubble, which is now bursting. The collapse will probably spread to other sectors and could cause a U.S. recession next year--and possibly a global recession.

So far this year, the broadest stock indexes are off 15% to 18% from their highs; the technology-heavy Nasdaq is off nearly 50%. A lower stock market is far from what U.S. households and businesses expected at the start of the year. Those expectations drove spending and borrowing to levels that were imprudent, because they required higher stock prices to be viable. The result of such imprudence will be sharply lower investment and consumption spending, probably starting by early next year.

The onset of the U.S. recession will be sharp. It will not be caused by Federal Reserve tightening, though the Fed will be blamed, but instead by a collapse of demand caused by falling equity prices. Investment and consumer spending tied to expectations of ever-rising stock markets will correspondingly drop.

Most recessions are caused by overheating. As the economy gets stronger and grows, households and businesses spend until demand growth outruns output growth. Prices start to rise, and the Fed pushes up interest rates and restricts liquidity until the economy slows down. Sometimes it takes a recession to convince the happy spenders to cut back, as in 1990; sometimes it just takes an economic slowdown, as in 1994 and 1995.

Yet, the signs of the sharp slowdown of investment and consumption ahead have little to do with interest rates and a great deal to do with the stock market. The extraordinary rise in the U.S. stock market has been fueled by strong investment growth--partly in the form of IRAs and 401ks--and productivity, coupled with rising consumption that has, in turn, relied on a zero level of savings by U.S. households.

The huge wealth increases generated by rising stock prices and the attendant, though much less spectacular, increases in real estate and bond prices have increasingly led U.S. households to rely on asset appreciation to achieve their savings goals. During 1999, wealth gains totaled $5.15 trillion, while savings fell to 2.2% of disposable income, far below the long-run average of around 7%. So far this year, wealth gains are zero or negative, and traditional savings have fallen yet again. But households have felt comfortable spending all their disposable income, and then some, because they achieved two years of wealth accumulation with the extraordinary rise in the stock market. Further, many appear reluctant to sell stocks and pay capital-gains taxes, preferring instead to borrow against them to finance continued spending.

The most important question about the outlook for the U.S. and global economies is this: If the U.S. stock market ends the year at or below current levels, what would that imply for investment and consumption behavior next year? The current consensus for a modest slowdown in spending overlooks the powerful negative effects on investment and consumption that could result from an absence of stock-market gains, let alone a broad drop in stock prices.

Until a decade ago, Americans wondered at the start of each year whether the stock market would go up or down. They saved about 7% of after-tax income to ensure that wealth would at least be maintained even if stock prices fell. By 2000, after nearly a decade of rising stock prices, Americans started the year wondering by how much the stock market would rise and saved nothing out of income, but relied instead on expected wealth gains to do their saving for them. U.S. businesses experienced a similar transformation of expectations about stock prices and undertook more aggressive spending and borrowing in 2000 as a result.

It is this transformation of expectations that implies magnified wealth effects from stock-market behavior during this year and next. The transformation also means that the U.S. economy is vulnerable to the extraordinary volatility generated by investment-led booms of the sort prevalent in the 19th century and the early part of the 20th century.

An investment boom starts when a new discovery or new technology opens immense opportunities for wealth creation. Investment growth surges, and output capacity is enhanced by more capital and greater productivity of capital. Growth accelerates, but inflation does not, thanks to higher productivity growth. The “new economy,” with faster growth and stable or falling prices, excites investors to bid up stock prices of new-economy companies. Another round of investment follows, thanks to the low cost of capital implied by a voracious appetite for new-economy stocks.

The first phase of a new economy appeared after 1995, when growth of productivity accelerated from 1% annually to nearly 3%. The second phase, after a 1998 global scare that benefited the U.S. with lower raw-material costs and lower financing costs enhanced by a Fed rate cut, began in 1999. It crested when dot-com companies could raise billions of dollars merely by suggesting an idea about the use of the Internet. Who wanted to build a refinery when there were hundreds of dot-coms in which to invest? In other words, the white-hot phase of the new economy is reached when traditional investments are starved for capital by a headlong rush into new-economy companies with seemingly limitless possibilities. Bottlenecks, like inadequate refining and drilling capacity and inadequate supplies of fuel or electric power, begin to slow the economy, just as excess capacity emerges in much of the new economy.

But investment does not just slow down when excess capacity appears. It stops. The capacity embodied in new capital equipment cannot be laid off. It has been bought and paid for, probably through borrowing. If too much information-technology equipment is on hand, IT orders are eliminated. That is why investment-led booms end suddenly.

If IT investment, which has accounted for virtually all investment and productivity growth since 1996, drops to zero, total U.S. growth will be cut by 1.5% to 2%. Productivity growth also would drop sharply, perhaps back to 1%. Real labor costs would rise, and a combination of rising labor costs and reduced pricing power (weakened by excess capacity) would depress profits. Stock prices would fall rapidly, especially in the face of dashed hopes of earnings of 30% a year or higher.

How plausible is the notion of a sharp drop in U.S. consumption? During the 1990s, capital gains have come to augment saving out of income as the way in which U.S. households accumulate wealth. On average, savings out of income plus expected capital gains has constituted about 15% of after-tax household income. With after-tax disposable income at about $7 trillion in 2000, the 15% rule would call for $1.05 trillion in savings. The fact that measured savings out of income is zero so far this year is consistent with the hypothesis that households in 2000 have not yet lowered their long-term expectation of substantial gains in wealth from higher stock prices.

In the past, households have moved gradually to achieve savings targets of 15% of after-tax disposable income during times of weakness in the economy. If we conservatively estimate the 2001 savings target as just one-third of $1.05 trillion--$350 billion--a reduction of consumption by that amount would cut 2001 GDP growth by 3.5%. A growth reduction of that magnitude arising from lower consumption, coupled with a sharp drop of investment spending that could take another 1.5% to 2% away from growth, is large enough to produce a recession in 2001.