Part of the reason, I believe, is because mainstream economics relies upon a model of human behavior of maximizing individual utilities. Those models break down when people’s utility functions can change other people’s utility functions, as can happen when investors get too optimistic or too pessimistic, and this mood is contagious.

Which is why I’m a fan of Paul Ormerod and his book, _Butterfly Economics_. A lot of people have also recommended _Black Swan_ to me, but I haven’t gotten to it yet.

See Stock Market Capitalization To GDP Ratio.

“borrowing money…” I was not clear enough on that point. of course borrowing money underpins modern capitalism. but when debt levels/leverage get too big, you have an economy swimming on money without the underlying value creation. debt is useful. too much debt is great for a while, then not so great.

as for GDP vs stock index … point taken (made above too). question: what is the economic orthodoxy when stock markets are soaring & GDP stagnant? does that indicate anything in particular?

As far as Peak Oil affects the market — there’s not a 1-to-1 correlation, because energy sources reach a peak (the maximum amount of that resource is discovered, discoveries then tail off after that), production efficiency is so high with demand equally high, so that it creates inelasticity. We tend to see the effects ripple out in a delayed form.

On your 3 ways of creating wealth, I would argue that #2 is really the same as #1. Cutting costs means producing more with less, which means you’re increasing productivity or efficiency. A better shovel, in other words. I wouldn’t consider the goal of layoffs to be wealth creation, but simply more of a firm’s reaction to changes in expectations about the future. Just like households cut back spending and tighten belts in lean times, so do firms.

As for borrowing money, it’s the main way anybody who doesn’t have wealth creates wealth. If you want to start a business, you either use your own capital to fund it or you borrow it (or you sell shares, but that’s typically a ways down the road). There’s nothing unsustainable about that. Even boosting investment profits using leverage is sustainable as well. Sure, you have to pay back the loans, but your gains are so much higher that this is not a problem.

The problem with debt is that too much of it creates systemic risk. Which is part of what happened here. I don’t think it’s the main part. The bubble I think was mostly the Federal Reserve increasing the money supply too much, combined with investors getting sloppy because everybody was making money easily. And then leverage, derivatives. etc. amplified the systemic risk posed by the bubble.

I do think your graph makes a good case that there was a stock market bubble (and indeed, I don’t think too many argue that point anymore). But GDP is a far better proxy for the economic value of the economy than any stock market index.

I think the housing bubble, while significant, was only part of a much more widespread problem.

I’ve normally heard the uptick circa 1993 explained in two terms:
1) The end of the Cold War led to a massive reallocation in capital away from the military/industrial complex (a hugely inefficient market) towards consumers (the invisible hand makes it much more efficient)

2) In the mid-1990s the productivity gains of investing in computers for a decade finally started to show up in economic stats. (Literally, in the early 90′s there were papers with titles like “Why do we use computers as they do not increase productivity”).

These gains in productivity led people to think that we were in the New Economy and since productivity makes everyone richer at no added costs, the S&P jumped.

From there it was the Internet Bubble and then cheap capital led to the housing bubble of ’06.