The extended stock market boom is showing signs of weariness. That is not, of course, the same thing as saying the market is about to crash. However, even though hot new tech issues will continue to post dramatic gains, the broad-based stock market averages are not likely to rise much more this year. The key question then becomes: What effect will this have on economic activity? Let's look at the ways in which rising stock prices have boosted economic growth:
- Higher consumption due to increased income from capital gains.
- Higher capital spending due to the lower cost of capital.
- A boost in consumer and business expectations beyond the gains from higher real income.
- Gains in overall aggregate demand from faster productivity growth and lower inflation.
Capital gains realized by individuals have risen from about $100 billion per year at the beginning of the decade to $250 billion per year. At the same time, total personal income, excluding capital gains, has risen from $4.9 trillion to $8.2 trillion, which is an increase of 5.3% per year. Including capital gains, the increase has averaged 5.4% per year. I don't think this is a major factor for the consumer boom. Some of the consumer boom can be attributed to lower interest rates, which in large part reflect lower inflation. Long-term interest rates have declined about 3% over the decade, which reduced the saving rate by 2%, or another $150 billion at 2000 levels. The final factor boosting consumer spending has been the improvement in consumer attitudes. Of course this would all be wiped out if the economy went back to 1990 conditions, with 6% inflation and 7% unemployment. But I'm saying that won't occur. If the stock market levels off, the personal saving rate would probably stop declining, but it wouldn't increase very much. Consumption would still rise at the same rate as overall GDP. The cost of capital is a much more important issue. Using the P/E ratio as a measure of the cost of equity capital, it has fallen from 7% to 3% over the past decade. At the same time the cost of low-risk debt capital fell from 9% to 6%, although it has recently risen back to about 7.5%. Of course the cost of equity capital is lower for high-tech firms, but to a large extent that has always been the case. High-tech firms may be selling at 100 rather than 50 times earnings now, which means the cost of equity capital is 1% instead of 2%. As a rough rule of thumb, a one percentage point change in the cost of capital usually results in a one percentage point change in the ratio of investment to GDP. Hence the rise in the ratio of purchases of capital goods to GDP from 7% in 1992 to 10% currently is presumably due to the corresponding drop in the cost of capital. Yet even that substantial increase in producers' durable equipment has a limited effect on the growth rate in aggregate demand; this increase adds only about 0.3% to the overall growth rate, a figure that might be as high as 0.5% when multiplier effects are included. That hardly accounts for the rise in productivity growth from 1% to 3%, which is primarily a supply-side phenomenon. The major impact of the stock market boom, then, has been to boost productivity and reduce inflation, rather than boost aggregate demand directly. It is not necessary for the stock market to keep rising at near-record rates to keep the boom alive; a flat market would be sufficient. Only a major market crash would reverse this scenario -- and in my view, the Fed wouldn't let that happen again, as occurred in 1987 and again in 1998. Indeed, one advantage of boosting interest rates now is that it gives the Fed a cushion to ease should equity market conditions turn sour. Just as the Fed quickly came to the rescue in the fall of 1998 and lowered rates enough to produce above-average growth last year, a similar rescue operation in the future seems the most likely course of action.
Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill. His e-mail address is [email protected]