The Dow Jones industrial average is up by almost half in the past year. The NASDAQ Composite Index and the S&P 500 are up more than 40 percent. Thanks to the portfolio tracking services on financial Web sites like Microsoft Investor, millions of middle-class investors are aware of their rising net worth, to the dollar, on a daily or even hourly basis. Troubadours of capitalism celebrate each new high as evidence of the system’s ability to create wealth.
But in what sense has the stock market boom created wealth? This is not a philosophical question. It’s a mathematical one. Nor is my point that a Dow breaking 8,000 is necessarily a speculative bubble that will burst (though I reserve the right to claim that was my point if it happens). But when we imagine how we will spend our stock market wealth, we’re engaged in an orgy of pre-hatch chicken counting. Is there any way the “wealth” that people are spending in their minds can be spent in reality–that is, converted into goods and services?
Here’s the puzzle. The shares traded on the New York Stock Exchange are worth a total of over $8 trillion. “Worth” in the sense that a) this is the sum of the prices they’re trading at, little bits at a time; and b) this is the sum of the numbers their proud owners mentally fondle. Perhaps $2 trillion of that “worth” has been added in the past year. Meanwhile, though, the entire U.S. economy produces goods and services of about $7 trillion a year, and grew less than 4 percent in the past year. Four percent growth is, in fact, very healthy. But it means that the increase in goods and services in the economy was $280 billion, less than one-seventh of the increase in claims on goods and services implied by the rise in prices on the New York Stock Exchange alone. Add the other exchanges, the NASDAQ, real estate, and various other investments, and the growth in the economy’s capacity to produce real wealth shrinks into insignificance compared with the increase in “wealth” as perceived by the owners of these investments.
No one loves a share of stock for its own sake. Even shares in a company as wonderful as, say, Microsoft are treasured only for their trade-in value. So what would happen if everyone suddenly tried to trade the “wealth” we’ve accumulated during the past year for real stuff–cars, houses, vacations, new washing machines, whatever? Two things would happen: Stock prices would plummet and the price of “real stuff” would rise. As a result, much of our perceived wealth would melt away.
Of course we’re not all going to cash in our stocks tomorrow. One thing sustaining current stock-price levels is baby boomers socking money away for retirement. But many experts have predicted that this pleasant dynamic will reverse itself when the boomer generation starts withdrawing and spending its retirement nest eggs. Instead of sustaining the market, the aging-boomer factor will be depressing it. The result needn’t be a crash. But some combination of stock-price stagnation or decline and general price inflation will deny boomers the value they think they’re accumulating.
(This is another reason that the notion of solving the Social Security problem by investing payments in the stock market is such folly. The infusion of these extra billions will drive prices up when boomers are all buying, and the subsequent withdrawal will drive prices down when boomers are all selling.)
So the alleged wealth accumulated in the stock market can’t be realized all at once now, and probably can’t be realized all at once decades from now. Can it be realized gradually over the years, as people sell off a little at a time? It’s possible, but pretty unlikely. Stock prices represent the discounted present value of a company’s future earnings stream. In other words: What you’re willing to pay for a share of stock is, or ought to be, equal to what you would pay today for the right to claim that share’s fraction of the company’s profits from now on. If prospects for future earnings have actually improved by 40 or 50 percent in the past year, the economy will generate enough wealth to cover all the new chits in people’s pockets.
There are two ways the present value of future earnings might have increased by 40 or 50 percent during a period when the economy’s general productive capacity increased by only 4 percent. One possibility is that companies were radically undervalued a year ago. The other is that something happened in the past year to improve general corporate prospects by 40 or 50 percent. In either case, stock prices and profit potential are, in theory, now correctly aligned.
B ut do you know of any dazzling new insight about the past, or revelation about the future, during the past year that would justify a 40 percent upward valuation of all of corporate America? Well, Ben Stein wrote in Slate a while back attributing the bull market to new understanding about the lack of risk in equity investments. Slate’s Paul Krugman notes that the past year has brought good news about the economy’s ability to tolerate low unemployment without igniting inflation. “But this news,” Krugman says, “makes us 2 or 3 percent richer at most–nowhere near enough to justify the rise in the Dow.” What’s more, if the past year’s huge rise in stock prices reflects a new but accurate optimism about future economic growth, this means the payoff for that future growth is already in the past. In other words, future stock-price increases will have to trail economic growth.
A related possibility: The increase in stockholder wealth could reflect a transfer from those Americans who don’t own stocks. Or from our own non-stock repositories of future value–i.e., our labor. Could it be that the rise in stock values reflects the ongoing shift, from labor to capital, of the return to production in our economy? In other words, we’re not producing 30 percent more, but more of what we do produce goes to corporate profits and less to wages? Well, Krugman maintains that no such shift is taking place. (Another economist, Lawrence Mishel, takes issue with Krugman in the current issue of the American Prospect.)
Then there’s what economists call the wealth effect. Even if the impression that we’re a lot richer than a year ago is a fantasy, the very fact that millions believe it might help make it come true. Prosperity is like Tinker Bell: It lives on belief that it lives. Folks who believe (even incorrectly) that their net worth is up by 40 percent will spend with zest, and the economy will thrive and grow as a result. Of course this kind of “demand-side” thinking is extremely out of fashion. After all, if spending money you don’t really have is the key to prosperity, big government deficits would do the trick just as well. Yet deficits are deeply unpopular, most of all with the sort of folks who celebrate the new wealth created by the stock market.
Of course this whole line of reasoning would apply to stock market crashes as well as to booms. The one-day crash of ‘87, for example, reduced people’s net worth by billions without directly reducing by as much as a single doughnut the amount of goods and services or the economy’s ability to produce more of them. Maybe the moral is just the obvious one that stock prices occasionally overshoot the mark in both directions. But maybe the moral is that the only folks who are going to get their full chicken’s worth out of the 8,000 market are those who stop counting their chickens and start trading them in.
