Since the mid-1990s, the American economy has adhered to a pleasurable cycle of higher confidence, spending, jobs and profits. The rising stock market has played a critical role in this chain reaction, transforming growing confidence into greater financial wealth, which in turn improved consumer spending, job creation, profits and investment. Good news fed on itself. Governments at all levels enjoyed unexpected tax windfalls. Federal budget deficits turned into surpluses. The central economic question now is whether the weakening stock market has broken this comforting cycle and, if so, what are the consequences.
Generally speaking, there are four possibilities: (a) nothing much changes–confidence and stock prices rebound, sustaining strong consumer spending and job growth; (b) the cycle is broken, but the effects are mild and helpful–slower consumer spending diminishes inflationary pressures; (c) the cycle is broken, but instead of a sharp recession, the economy settles into a long period of sluggish growth (much like Japan’s stagnation in the 1990s); or (d) the economy experiences a sharp recession–falling stock prices depress confidence, consumer spending, profits and investment.
No one knows which possibility will occur. Since World War II, most business cycles have submitted to the strengths and weaknesses of government policies (easy credit, tight credit, expansionary budgets and the like). By contrast, private passions and private markets have largely regulated this cycle. That’s one reason why it’s been so unpredictable. Given the economy’s record of resilience, the first possibility (nothing happens) is conceivable. After all, Asia’s financial crisis barely disturbed growth, and previous stock plunges had little lasting effect. Recall: on Oct. 27, 1997, the Dow dropped 554 points, or 7.2 percent; on Aug. 31, 1998, it declined 513 points, 6.4 percent.
Still, this latest episode is troubling. Since market indexes hit historic highs earlier this year, there seems to be a pattern. Some bit of bad news causes a sharp drop. The market recovers some (but not all) of its losses. Then something else retriggers the pattern. For starters, market speculation had intensified over the past year. Prices of some stocks (famously, many dot-coms) rose to preposterous levels, on the faith that stocks could be sold at ever-higher prices. This implies that the confidence (and wealth) based on some recent stock gains was increasingly artificial.
Lower stock prices also threaten the huge flow of cheap capital to high-tech companies (from venture capital funds and “initial public offerings”). It has financed new hiring, computer purchases, office construction and splashy advertisements. This spending may slow. Some start-up companies will exhaust funds. Presumably, they will go out of business or merge into wealthier firms. Finally, there’s the Federal Reserve. In 1998, it lowered interest rates to offset the economic crisis abroad. By contrast, the Fed has been raising rates since mid-1999 to prevent the spending boom from igniting inflation.
All this suggests that the economy will weaken–but not by how much. Considering its strength (in the fourth quarter, gross domestic product grew at an annual rate of 7.3 percent), a slight slowdown would be a godsend if it restrained inflation. But a severe slowdown would be something else. The “how much” question may depend largely on two factors.
The first is the rest of the world. In 2000, Europe’s economy may grow 3.2 percent, forecasts the International Monetary Fund. Asia’s (outside of Japan) may grow roughly 6 percent. This growth–assuming it no longer depends exclusively on exports to the United States–would help. American exports would strengthen just as domestic spending was softening.
But what counts more is the psychology of the American consumer. Almost everything that’s supposed to be “new” about the New Economy has happened before. Despite computers, productivity gains (increases in efficiency) were larger in the 1950s than in the 1990s. Unemployment was lower in the late 1960s than now. The one truly distinctive feature of the New Economy is that consumers–as a group–have virtually stopped saving. In 1991, the personal savings rate (savings as a share of after-tax income) was 8.3 percent; in 1999, it was 2.3 percent.
Every percentage point drop in the savings rate is worth about $66 billion in extra consumer spending. Americans may still make deposits in savings accounts or 401(k) plans. But consumers offset these savings by borrowing or by spending stock profits. It is this spending spree–based heavily on people’s stock wealth–that has expanded the economy, profits and hiring.
The point is that the stock market’s drop can’t be dismissed because “the economy’s fundamentals are strong.” The market is one of the fundamentals. If the market doesn’t upset consumers, the boom continues. If the market terrifies consumers, the boom stops. Between those extremes, there are endless possibilities. Wall Street is Main Street.
