It’s not that the past decade’s prosperity was unprecedented. In many ways, the affluence of the 1950s and 1960s was more satisfying. Living standards rose faster, and coming after the Great Depression of the 1930s–when unemployment averaged 18 percent–the good times were more surprising. Nor have recent economic reverses set new misery records. In the early 1980s, interest rates and unemployment both hit double-digit levels as the Federal Reserve repressed 13 percent inflation. Even the stock market’s recent carnage can be matched. From December 1972 to December 1974, the market lost almost half its value, notes economist Donald Straszheim. But what does distinguish the present period is its spirit. We have come through a decade when entrepreneurs, venture capitalists and stock promoters–a new generation of tycoons–dominated the headlines and advanced the economy with their inventions, investments and deals. The era glorified self-enrichment for the elites and the masses alike and was personified in the astounding fortunes of a new class of business buccaneers: the Bill Gateses, Bernie Ebbers, Steve Cases and Ken Lays. The contrast with other postwar decades seems stark: with the 1950s and 1960s, dominated by the faceless “organization men” of big corporations; and with the 1970s and 1980s, preoccupied by the alleged failings of U.S. managers compared with their Japanese and German rivals.
It is too early to say how history will judge the present era. Just as the euphoria of the “new economy” was unreliable, so the present obsession with scandal may prove misleading. The first was too optimistic; the second may be too cynical. We may conclude that the freewheeling nature of American capitalism, a system that encourages people to make the most of their ideas and ambitions, confers enormous benefits while exposing us periodically to huge economic mistakes and ethics lapses. It is less premature to suggest that popular judgment may hinge on the answer to a simple question: will the falling stock market drag down the rising “real economy” of jobs and production–or will the rising real economy revive the market?
If the real economy continues to improve, it will probably halt the market’s decline–and maybe cause a rally. Americans might then view the present orgy of corporate scandals as a sideshow, an interesting window on the frailties of human nature but not a fundamental indictment of the economy’s soundness. But if the falling market weakens consumer confidence and spending, it could herald a prolonged period of meager economic growth or even a “double dip” recession. The backlash against corporate America and Wall Street would likely intensify, while the economic boom of the 1990s would be cast in a harsher light.
Whatever happens, the disconnect between the market and the real economy is vast. Since its peak in March 2000, the market’s “capitalization” (the value of all traded shares) has fallen 45 percent or $7.7 trillion, reports Wilshire Associates. Aside from vanished dot-coms and telecom companies–whose shareholders have been wiped out–the stocks of many solid companies have dropped sharply from their peaks: General Electric ($26.52 at the close on July 19), down 56 percent; Intel ($18.65), down 75 percent; Disney ($16.64), down 62 percent, and Coca Cola ($45.09), down 49 percent.
Meanwhile, the real economy plugs on. Since May, companies have hired small numbers of workers. The unemployment rate of 5.9 percent in June, though well above its recent low (3.9 percent in October 2000), is not especially high by post-World War II standards. Home buying, with the associated spending on appliances and furniture, has remained strong. Low-interest-rate loans and price discounts have sustained auto sales. Just last week the Federal Reserve reported the sixth monthly rise in industrial production.
Aside from being huge, the disconnect between the market and the economy may be unprecedented. In the nine previous economic recoveries since World War II, stocks always rose before the recession’s low point and continued rising during the early expansion, says economist Jan Hatzius of Goldman Sachs. On average, stocks (measured by the Standard & Poor’s 500 index) were 27 percent higher after six months of recovery than a year earlier. Assuming the present recovery began in December 2001, stocks are now about 25 percent lower than in June 2001 (based on July’s average prices).
Despite that, most economists think the real economy will prevail. Testifying before Congress last week, Federal Reserve chairman Alan Greenspan declared: “The fundamentals are in place for a return to sustained healthy growth.” The Fed’s policymakers actually raised their forecasts of economic growth for 2002 and 2003, and predicted that unemployment would drop to somewhere between 5.25 percent and 5.5 percent by the end of next year. Aside from the Fed’s low interest rates, the rising federal budget deficit–though widely deplored–has supported the economy. Tax cuts have helped consumers; spending increases have saved jobs.
As for stocks, losses are “being partially offset by rising housing wealth,” says economist Nariman Behravesh of DRI-WEFA, a forecasting service. True. In March, households’ net worth (what people own minus what they owe) was $40.2 trillion, down only slightly from $41.7 trillion at the end of 1999. For the year ending in March, home prices were up 8 percent nationally, says the National Association of Realtors. The increases were 14 percent in San Diego, 7 percent in Chicago and almost 5 percent in New Orleans. Low mortgage rates, high employment and (perhaps) a retreat from stocks have helped housing.
A continuing rebound from so many setbacks–September 11, the dot-com bust, the stock-market “bubble”–would be impressive. The trouble is that all forecasts must be qualified because economists are dealing with something they’ve never seen before. It’s not just that the previous economic expansion, ending in March 2001, was the longest in U.S. history: 10 years. It is that the boom itself was unlike anything that had occurred since the 1920s, when enthusiasm for new consumer industries (cars, radios, electric utilities) and a “new era” economy also ignited household spending and stock speculation.
To be fair, the latest boom stemmed from more than speculation. The largest cause was the suppression of double-digit inflation, starting in the early 1980s. Declining inflation meant lower interest rates, less uncertainty and rising stock prices. (The market’s rally really began in 1982, when the Dow averaged 884. By 1992, it had almost quadrupled to 3284.) But in its final years, the boom fed off surging stock prices, an outpouring of investment in new technologies–computers, the Internet, telecommunications–and boundless consumer confidence, further emboldened by falling unemployment rates. From executive dining rooms to corporate cafeterias, a get-rich-quick mentality took hold.
The question now is how gracefully (or not) the economy decompresses. The best comparisons stretch from the 1920s back to the 19th century, when American capitalism seemed particularly rapacious and single-minded. Then as now, the public stage was dominated by captains of industry, financiers and speculators–the Andrew Carnegies, J. P. Morgans and Jay Goulds. Then as now, the economy responded highly aggressively to new opportunities for greater wealth.
Consider the 1830s. Land speculation gripped the Midwest, reflecting rising hopes for selling farm products in Eastern markets. “There was enormous optimism about the worth of land,” says University of Maryland economist John Wallis. From 1831 to 1836, annual federal land sales jumped from 1 million acres to 20 million acres. States borrowed lavishly for canal construction to speed wheat and hogs to the East. With an annual budget of only $50,000, Indiana floated $10 million in bonds. A building boom ensued. Land values soared. “They’re like dot-com prices in 1999,” says Wallis. But the enthusiasm was overdone. By 1842, eight states and the territory of Florida had defaulted on their debts. Construction, land prices and the economy collapsed.
Even now, the 19th century’s booms and busts are poorly understood. But most busts shared one or both of two characteristics: overexpansion in some sector and financial panic. A crisis in 1873 was partly caused by “a period of catch-up and overexpansion” in railroad construction after the Civil War, says economist Jeremy Atack of Vanderbilt University. Periodic banking panics occurred because overexpansion caused losses–or because people believed that, through fraud or stupidity, banks had squandered their deposits. Busted banks meant lost savings and less credit.
The U.S. economy has changed hugely since then. In 1913, Congress created the Federal Reserve to prevent banking panics. The Fed also tries to temper the economy’s cycles. Deposit insurance, enacted in the 1930s, similarly protects against banking panics. Still, present parallels with the distant past seem plain. Everyone recognizes the overexpansion in the dot-com and telecom sectors, imperiling firms as large as WorldCom, Cisco, AT&T and AOL Time Warner. Their distress has spread. Since year-end 2000, office-vacancy rates have virtually doubled to 14 percent in cities and 19 percent in the suburbs, says Maria Sicola, research director of Cushman & Wakefield, a real-estate advisory firm. Developers overbuilt. Empty space from bankrupt and hurting dot-com and telecom companies has expanded surplus supply. Rents have slumped and construction slowed.
The stock market–not the banking system–poses the financial parallel. The danger is that its weakness will radiate and weaken the real economy. Business investment has already suffered, because IPOs (“initial public offerings” of stock) are no longer an easy source of funds. But the real vulnerability is consumer spending, which has been the economy’s main pillar. Economists believe that for every $1 change in stock-market wealth, consumers ultimately adjust their spending by three to six cents: up in a rising market, down in a falling market. Superficially, the immense losses (that $7 trillion-plus) imply hundreds of billions of less spending: fewer cars sold, clothes bought or restaurant meals eaten.
This arithmetic may be misleading, because stock values at the market’s top existed only momentarily, and investors may believe that some recent losses will soon be reversed. But the longer the market stays down, the more dangerous its possible adverse side effects. Some otherwise-optimistic economists are already rattled. “The recovery isn’t going anywhere fast without the market moving up,” says Mark Zandi of economy.com. Like many–though not all–commentators, Zandi thinks stocks have declined enough to make them a good buy. But that doesn’t guarantee the market will rise.
What we have to fear now is (to borrow from Franklin Roosevelt) fear itself. The danger is yesterday’s widespread and foolish optimism becomes tomorrow’s widespread and foolish pessimism. For all the present focus on financial fraud, the basic reason that the stock market got wildly overvalued was that people believed in tooth fairies, which–in the late 1990s–became outlandish stories about the Internet and the “new economy.” The most overpriced stocks belonged to companies with no profits at all. But the enthusiasm was, for a while, self-fulfilling, as stock prices rose and caused consumers to spend. Unemployment dropped, profits increased, government tax revenues jumped. The rest of the world benefited by greater exports to the United States.
To contemplate the mirror image is unnerving. It suggests a progressive disenchantment with stocks that holds down the market, also with self-fulfilling (and chilling) consequences: weak consumer spending, poor profits, low investment, meager tax revenues and feeble support for the world economy. There might even be a general price deflation. And social and political recriminations would surely increase. Speculative markets (whether of stocks, land or office space) inflict inevitable losses, because prices have risen to unsustainable levels. In the aftermath, the economic casualties search for explanations and scapegoats.
History continues. What we learned in the 1990s–and the 19th century taught the same lesson–is that mood and psychology matter. If they behave on the way down as they did on the way up, American capitalism’s next chapter won’t be a happy one.
