Since the middle of the 1990s the US stock exchange has played a pivotal role in the expansion of the world economy. With Europe stagnating until recently and Japan stagnating still, the American economy has been the OECD’s locomotive. The long US boom, dissected by Robert Pollin (NLR 3), has been underpinned by very rapid growth of household consumption. Rising share prices have allowed the well-off to increase their spending by realizing capital gains or borrowing against them. If the stock market continues rising, then capital gains will continue flowing, consumption will remain buoyant and the growth of the US economy will be limited only by the growth of its productive capacity. If the stock market stops rising (as it has in recent months) American economic growth will slow and a ‘soft landing’ to a more moderate growth path is possible. But if the stock market falls to much lower levels, it would precipitate a severe recession. Spending would drop as households rushed to repay borrowings and build up depleted savings, just as happened in many countries at the end of the 1980s, when consumption booms based on credit collapsed spectacularly. The upsurge in US corporate investment would falter. The government’s budget surplus would disappear as tax revenues declined. The dollar would plummet as investors sought safer havens elsewhere—vainly, as bourses abroad would fall in sympathy. The medium-term perspectives for the world economy literally rest on the Dow Jones index.
‘Irrational exuberance’ was how Alan Greenspan characterized the rising stock market at the end of 1996. Robert Shiller, the Yale economist who testified before the Federal Reserve Board just prior to Greenspan’s speech, and so has some claims on the notorious phrase, has written an accessible, interesting and worried book aimed at probing the exuberance and justifying its label as irrational. It is easy to demonstrate that stock prices are at unprecedented levels. Shiller shows that the US stock market is valued more highly than ever before, including 1929, in relation to the trend in corporate profits which it is supposed to reflect. But has the rise in the stock market been irrational? The orthodox view today is ‘Efficient Markets Theory’ (EMT). This disputes that the valuation of shares or indeed any financial asset (including currencies like sterling) could ever be ‘irrational’. Shiller has been in the forefront of those questioning this view, along the lines of the critique of speculative processes in financial markets sharply outlined by Keynes (who, amazingly, does not rate a mention in Shiller’s index).
The rationality of financial markets is the key premise of the worldwide drive towards financial deregulation. By pricing all investment opportunities according to their underlying worth, and parcelling out risks to those most willing and able to bear them, capital is allocated to wherever it can be most productive and profitable; any interference with this process reduces economic efficiency and therefore GDP. Such is the theory.