The Times' Simplistic Market Alarmism

The business section of Sunday's New York Times had a quiet, but definitive, feel of "Apocalypse Soon," featuring as it did three different columns arguing that the stock market was patently overvalued, that this overvaluation would eventually be corrected--perhaps in the form of a crash--and that that crash would have dramatic ripple effects on the rest of the economy as a whole even if, as seems certain it would, the Federal Reserve were to step up and cut interest rates to keep liquidity in the system.

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On a day when the Nasdaq rose 127 points to yet another record high, putting it up 77 percent on the year, this scenario may seem more plausible than ever. But what's interesting is that even if you set the question of overvaluation aside--and it is a much more complicated question than anyone at the Times ever seems to acknowledge--and accept that some form of market correction is in the offing, it's really not clear that a major correction would have such a dramatic impact on the economy as a whole.

It's not clear because the evidence for a causal relationship between a booming stock market and a booming economy remains surprisingly scanty. For the most part, it's accepted that there is such a thing as a "wealth effect," whereby some percentage of every dollar people make in the stock market is turned into consumption. But the magnitude of that wealth effect has, at least in the past, been shown (insofar as something like this can be shown) to be relatively small, on the order of three to five cents in additional spending per dollar. Over the past few years, as the economy has grown at a much faster than anticipated rate and the stock market has also risen sharply, the media and Wall Street seem to have assumed that the size of the wealth effect has also increased, and that more of every dollar in market gain is being turned into consumption (which in turn drives the economy). But that remains very much an assumption that has not been proven.

Gretchen Morgenson, for instance, cites as proof of the stock market's effect on spending a study of the past couple of years showing that retail spending and the stock market have risen quite briskly and seemingly in tandem. But contiguity is not causality. There probably is a virtuous circle at work in which the strength of the economy as a whole pushes up stock prices, the gains from which are then put back to work in the economy. But drawing a strict one-to-one relationship between the market and consumer spending requires more work than just citing a couple of monthly numbers.

It's become easy to accept this argument, of course, because the stock market has taken on such tremendous cultural prominence in the 1990s, and has become, in fact, the key symbol of this decade's economic boom. But it is just a symbol. Consider, for instance, that just 21 percent of Americans have money in the stock market outside of their retirement funds (and just 48 percent have money in the stock market at all). Given what we know about the way people use mental accounting in order to manage their money--putting different kinds of money into different kinds of accounts, rather than thinking about their money as part of a single account--it's hard to believe that people are out there spending lavishly because their 401Ks, which they know they won't be touching for decades, are flush. And most Americans still don't have 401Ks at all.

This isn't to say that if the market were to swoon significantly the American economy would not suffer, particularly since the cost of capital for young companies would rise and the use of stock options as compensation (which has helped keep down wage pressure) would be limited. But it is to say that the U.S. economy is so big and diverse, and still so driven by the consumption of people with very little or nothing at all invested in the stock market, that GDP remains a better indicator of the economy's health than the Dow does. If there is an apocalypse soon, something other than the stock market will have to create it.

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