Two years ago in this space, just before the peak in US equity markets, I asked what the implications might be if technology stocks were valued fairly. The answer was that to generate enough future income to justify prevailing prices, Americans would have to spend most of their lives enjoying virtual sex with animated avatars. For what other purpose would we need all that broadband?
As it turns out, existing infrastructure was quite sufficient for Americans’ principal uses of data communications, namely, downloading pornography and swapping popular songs. Would America have been better off in the case that the market had been right? Had the American stock market continued to rise rather than crash, would America be better off today? What precisely would be different?
More upper-middle-class Americans would have retired early, depriving the economy of many of its most talented professionals and managers. More Americans would have worked less and bought more luxury goods, trading capital gains in the equity market for the labor of other countries, and increasing America’s trade deficit. In 2001 America’s trade deficit exceeded 5 percent of its GDP, as foreigners sold their goods to buy US risk assets.
Talented students would have continued to abandon their education to start up copycat Internet sites. The folk heroes of popular culture would have been 20-year-old computer geeks wearing backward-turned baseball caps and flip-flops, with the aesthetic sensibility of a junkyard dog.
In short, America would have been subject to the curse of wealth. With the collapse of equity prices, the curse has been lifted, and America is much better off for it. In the extreme, the curse of wealth produces hydrocephalic economic monsters. Bernard Lewis is fond of observing that 300 million Arabs export the same value of goods as 5 million Finns, apart from oil, of course.
There are other societies in which no one works and everyone is rich. Greece is bursting with wealth, but no one seems to work very much. Taxi drivers take three-month vacations. Commercial bankers earn perhaps a fifth of their American counterparts’ compensation. Yet Athens daily grows in resemblance to Los Angeles. Greece pumps no oil, but the average Greek family owns half a dozen pieces of property scattered throughout the country, the cumulative inheritance of a rural population that has emigrated. Selling vacation property to Americans and Germans has made Greeks wealthy. To spend its wealth without working, Greece must import labor, and has done so to the point that the cultural clash with immigrants has become a dominant theme of Greek politics.
But the curse of wealth has been lifted from the fortunate shores of the United States. Now that America’s broad market indices have fallen nearly 50 percent from their peak, millions of Americans in their 50s and 60s who expected to spend the next 20 years on the golf course will have to remain in the labor market. Rather than earning 20 percent a year on savings in the stock market, Americans will be resigned to earning 5 percent in the bond market. That means they will have to save more. Rather than cut back consumption, they will work for another five or ten years.
But don’t markets provide an unbiased estimate of future economic growth, as the textbook tells us? Doesn’t a collapse of equity prices show that something is terribly wrong at the heart of the American economy?
I see no reason to draw this conclusion. Indeed, equity valuation is the scandal of finance theory. Equities offer dividends in perpetuity. To form a view of future cash flows we must imagine a far distant future. Technologies arise which transform our lives. Children no longer die of diphtheria. Farmers no longer must live within horse-and-wagon distance of a city. Scribes no longer must copy documents by hand. We only can imagine how our lives might change.
But it is meaningless to speak of “unbiased estimates” when it is such a trivial exercise to bias estimates. A standard classroom demonstration employs a large jar full of beans. The students are asked to write down their estimate of the number of beans in the jar. If the sample is sufficiently large (100 or more) the average estimate usually comes quite close to the correct number. Then the students are told that the jar’s glass is deceptively thick. Once bias is introduced in this fashion, the estimates go wide from the mark.
Cultural bias suffuses our view of the future. During the 19th century the problem was transmission not so much of information, but people and freight. Cheap freight offered by competitive rail lines brought millions of farmers to the American heartland, many to marginal land. Like today’s telecom companies, the American railroads went bankrupt, some two or three times over, as the pioneer dream overreached and collapsed.
By the 1890s, historians pronounced the frontier dead. E H Harriman and J P Morgan bought up the bankrupt railroads and established profitable monopolies, and in the process ruined millions of marginal farmers. This begot a populist movement, the myth of the evil monopolist, and a whole literature about rural tragedy.
In today’s case the dream had psychedelic colors and a techno beat, and its demise may be a blessing. This time, the tech bubble collapse has ruined millions of marginal investors, as another dream of the future overreached. The public is shocked, shocked to discover that corporations window-dress their earnings, and equity valuations suffer a downward bias due to universal paranoia about accounting fraud.
Federal Reserve chairman Alan Greenspan observed in congressional testimony last week that the national income and product account profit estimates, which are based on corporate tax collections, show a modest but significant improvement. If that is the case, Greenspan concluded, the actual profitability of corporations must be rising (because corporations do not wish to pay taxes on inflated earnings). America is doing just fine, thank you, and will be better for the cold bath.