August 26, 2018
The NYT had a major editorial arguing against the rush by Republicans (and some Democrats) to selectively deregulate the financial sector. (It is important to note that the industry doesn’t want to eliminate government protections that benefit it, like deposit insurance or the Fed’s support in a crisis.) The gist of the piece is that we are lurching towards another 2008–09 financial crisis. (It is titled “inviting the next financial crisis.”)
The highlight of this argument is the high value of the stock market:
“Consider the stock market, which has shot up after the tax cut was enacted; the S.&P. 500 stock index closed at a new high on Friday. Many analysts argue that the market is not overvalued and has room to run — comments eerily similar to what Wall Street’s salesmen were saying in 2007 and 2008. Yet, the market appears to be more overvalued now than it was before the crisis, according to an indicator created by Robert Shiller, the Yale economist who won a Nobel Prize for his work on bubbles in the stock and real estate markets. His data show that the S.&.P 500 stock index has an adjusted price-to-earnings ratio of 32.29, which indicates that investors are willing to pay $32.29 for $1 of corporate profits. In 2007 and 2008, that ratio never reached 28.”
There are two big problems with this story. The first is that Shiller “adjusted price-to-earnings” ratio is probably not a good guide right now. The 10-year look back period includes the very low profit years of the recession. It also doesn’t pick up the fact that profits have jumped around 15 percent this year because of the tax cut.
It would be great news if Congress were to repeal the tax cut, it is not leading to the promised boom in investment, but that doesn’t seem likely any time soon. It also would be great if profits were eroded due to wage gains. This has been happening to some extent over the last four years, but very slowly. The ratio of stock prices to current earnings is less than 19. That is somewhat above the historic average, which is less than 15, but not hugely out of line, especially in a low interest rate environment.
The other problem with this scare story is that nothing terrible happens if the stock market falls 20–30 percent. We got a recession in 2001 from the bubble bursting because it had led to an investment boom and a consumption boom. That is not true today as both investment and consumption are at very moderate levels. There would likely be little economic fallout from even a large decline in the stock market and it would drastically reduce wealth inequality.
This doesn’t mean the NYT is wrong about the Republicans’ regulatory changes. They will increase economic waste and redistribute income upward. The financial sector is providing an intermediate good. It allocates capital. It is not a good like education or housing where we, in principle, want more. We would like the financial sector to be as small as possible to serve its economic purpose. The Republican agenda will lead to a more bloated financial sector.
However, the idea of the next crisis being around the corner shows that the NYT still has not learned the lesson of the last crisis. A major crisis like the crash in 2008–09 does not just sneak up on us. It was the result of policymakers at the Fed and elsewhere ignoring evidence that was almost impossible to miss about the growth of the housing bubble and the impact it was having on the economy.
It is convenient for many people to act as though this was difficult to see at the time. It is not true.