Federal Reserve Chairman Alan Greenspan raised a fascinating point in recent congressional testimony when he worried aloud about "wealth effects" of the booming stock market. To hear Greenspan tell it, the overheated market is performing an almost Keynesian role. As he explained to the Senate Banking Committee in testimony on Feb. 22, the Fed estimates that 2 cents to 4 cents out of every additional dollar of stock market value is eventually reflected in increased consumer purchases. In other words, stock values are stimulating consumption, which in turn stimulates economic growth.
The implications of this insight are revolutionary--and troubling. For one thing, this account turns the old supply-side view of the booming economy on its head. In the supply-side story, increased rewards to capital increase the incentive to save and to invest, which in turn drives growth. But thanks to high stock prices, personal savings are actually at an all-time low. People with increased paper wealth feel more affluent, and spend and borrow more freely, consuming all their earned income. What little is saved by some households is borrowed by others, leaving the net personal savings rate close to zero.
Greenspan's account also underscores the economy's precarious dependence on foreign capital. Seemingly, global investors have unlimited confidence in the dynamism of the U.S. economy. In the short run, the Fed's decision to raise interest rates will only attract more capital to our shores. But looking down the road, our escalating current-account deficit and our dependence on external financing are probably unsustainable.
SOARING DEBT. Data in a recent paper, Seven Unsustainable Processes by Wynne Godley of the Jerome Levy Economics Institute, show that net foreign holdings of assets in the U.S. have risen to more than 20% of gross domestic product and could reach about 50% of GDP in a decade. Moreover, the current boom is heavily dependent on both domestic borrowing and foreign capital. Although the public budget is now in surplus and public debt is coming down relative to GDP, private debt, both household and business, has skyrocketed to nearly 300% of GDP, according to Jane D'Arista of the Financial Markets Center. Of Godley's seven unsustainable processes, the most serious are the economy's increased dependence on private-sector borrowing, its increased foreign indebtedness relative to GDP, and the rise in stock prices at a rate that far exceeds increases in profitability, productivity, or national income.
A further implication of Greenspan's analysis is that prosperity narrowly based on a stock market inflation is rather more precarious than one based on broadly distributed purchasing power. My friend Barry Bluestone, in his book Growing Prosperity, written with the late Bennett Harrison, contrasts the economic model of the postwar boom with the model of the 1990s. In the former, rising real wages and increasing income equality led to balanced and sustainable growth and rising private and public investment. In the current model, the economic engine is private borrowing, a stock market explosion, and a relatively narrow prosperity rooted in asset inflation. Productivity growth is up, but it may not be sustainable if the financial imbalances continue.
LURKING DEMONS. Indeed, the final concern raised by Greenspan's testimony is the danger of a major disconnect between the financial economy and the real one. The contribution of information technology to higher productivity is real and undeniable, but not nearly high enough to justify the dot-com euphoria or to keep the financial demons at bay. The 1920s and 1930s, let's recall, were also an era of amazing technological breakthrough--in radio, television, telephone, electric power generation, mass production, and aviation--and none of it was sufficient to counteract catastrophe when investors lost confidence and financial markets unwound.
What to do? In the short run, the Fed will raise interest rates in the hope of attaining the proverbial soft landing. But this is a very delicate exercise, especially if it's the superheated stock market that keeps the shaky boat afloat. If the market ever undergoes a serious contraction, both our ability to service debt and our ability to continue attracting the necessary capital from abroad could be compromised, leading the whole cycle to go into reverse and the slump to become self-reinforcing. This is why Greenspan, though he believes the stock market is overvalued and the current growth rate unsustainable, is proceeding very gingerly. If, indeed, the economy is a bubble, one needs to take special care to somehow let some air out gradually, rather than just popping the whole affair.