CEPR Releases Study on the Cost of the Stock Market Over-Valuation
For Immediate Release: October 18, 2000
Contact: David Levy: (202) 293-5380
The Center for Economic and Policy Research (CEPR) released a new study today that examines the costs associated with the stock market bubble. The study was written by CEPR's co-director, Dean Baker. Dr. Baker was one of the first economists to call attention to the over-valuation in the stock market in papers that he published in 1997.
The study places the size of the market's over-valuation at between $8-13 trillion, depending on assumptions about future profit growth and long-term equity premiums. The impact of this sort of over-pricing of assets is very large. For example, the paper estimates the stock market bubble has, by spurring consumption through the wealth effect, crowded out at its peak the same amount of investment as a $320 billion government budget deficit. The consumption spurred by the stock market bubble has also been a major contributor to the U.S. trade deficit. The United States is currently borrowing more than $400 billion a year from the rest of the world. This is money that otherwise could have supported investment in developing nations.
The study also points out that the deflation of the bubble could have substantial inflationary effects on the economy through two separate channels. First, workers who are currently being paid part of their compensation in stock options may demand higher wages and salaries when these options prove worthless. Second, the rising stock market has contributed to an inflow of money that led to an over-valuation of the dollar. When the dollar falls back to a sustainable level, it will raise the price of imports, which will place upward pressure on inflation. The combined impact of these two effects could raise the rate of inflation by more than 3 full percentage points.
The bubble has probably led to tens or hundreds of billions of dollars of misallocated investment, as money that could have been productively invested elsewhere was instead wasted on poorly conceived schemes in the Internet or high-tech sector. It will only be possible to estimate the size of this stock market-induced mis-investment after the correction, when the number of failed companies will peak.
The bubble has also had a substantial re-distributive effect. While some of this occurs within generations, the largest effects will be between generations. The older generation of workers that is discarding its stock at present is a big gainer from the bubble. On the other hand, younger generations of workers, who are buying into a hugely over-valued market, are likely to be big losers. A worker who began putting $1,000 a year in the market in 1995 could lose as much as $17,000 by 2010 as a result of the market's over-valuation. The losses incurred by younger workers will be larger if it takes longer for the stock market to correct to its proper value. As the paper points out, for middle income workers who invest in the stock market, the potential losses due to the bubble vastly exceed any costs that these workers might reasonably incur because of higher Social Security taxes in the future.
A market correction could lead investors to exaggerate the risks associated with the stock market in future years, thereby increasing the cost of capital for firms seeking to raise money in the market. This is exactly what happened after the 1929 crash.
Finally, a stock market crash is likely to lead to a sea of litigation as investors try to recover some of their losses from corporate executives who may have provided misleading information or stock brokers and financial advisors who gave bad advice. Such litigation could impose significant costs on the economy for some time to come.
As the paper notes, economists are usually concerned when prices are wrong. The stock market bubble has led to prices being wrong by between $8-13 trillion. It stands to reason that mis-pricing of this magnitude will have very serious economic consequences. This paper is the first effort to try to determine what those consequences are likely to be.