Double Bubble: The Implications of the Over-Valuation of the Stock Market and the Dollar

May 31, 2000

Contact: Karen Conner, (202) 293-5380 x117

May 31, 2000

Double Bubble: The Implications of the Over-Valuation of the Stock Market and the Dollar

For Immediate Release: May 31, 2000

WASHINGTON, DC– The Center for Economic and Policy Research (CEPR) is releasing a new paper by its co-director Dean Baker, which examines the over-valuation of the stock market and the dollar. The paper relies on past work that Dr. Baker has done on the stock market, along with more recent work by M.I.T. Professor Peter Diamond and Yale University Professor Robert Shiller, to show that current stock prices are inconsistent with plausible projections of future profit growth. Baker’s analysis shows that stock prices would first have to decline by close to 50 percent, in order for stocks to subsequently provide returns that are near their historic rate.

Baker similarly shows that the dollar is significantly over-valued. The United States is now running a current account deficit of more than $450 billion a year. Deficits of this magnitude cannot be long sustained, as the paper demonstrates. The paper also shows that the deficit cannot be brought down to manageable levels with plausible increases in the growth rates of U.S. trading partners. Only a large decline in the value of the dollar will be able to bring the trade and current account deficits down to manageable levels in the foreseeable future. Baker estimates that a decline in the value of the dollar of 20-30 percent will be needed to bring the current account deficit down to a sustainable level.

After demonstrating that both current stock prices and the value of the dollar cannot be sustained, the paper presents some of the likely results of the expected corrections in both markets:

The decline in stock prices would reverse the wealth effect of recent years, destroying as much as $9 trillion of paper wealth ($30,000 per person). This could reduce consumption by more than $350 billion a year.
A plunge in stock prices would dramatically reduce the revenue collected from capital gains taxes. Revenue from the capital gains tax is currently projected at more than $900 billion over the next decade.
There could be substantial supply-side effects from a stock plunge, as workers who receive part of their compensation in stock options instead demand straight salary. This could lead to serious disruptions in the labor market in those sectors where stock options are most widely used.
There also could be considerable disruptions from legal actions, as lawsuits over misrepresentations of profit and revenue prospects are likely to be common.
The decline in the dollar would add between 1.4-2.1percentage points to the annual rate of inflation. The Federal Reserve Board would thus face a choice between accommodating a higher rate of inflation, or raising interest rates at a time when the economy would already be suffering from the fallout of a plunging stock market.

The paper describes the severity of the problems that will be created by the collapse of the two bubbles, and argues that these problems will be worse if these bubbles are allowed to persist. The full paper is available here.