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Value, Bubbles, S&P

Wealth ought to come from the creation of value. That is, by designing and selling a better shovel, you make it easier for farmers to dig irrigation trenches which increases their yield. With your shovel, their output goes from 100 to 200 units a year, and so you, as shovel-maker get to benefit from a proportion of that 100 increase. It’s “worth” giving you a cut, since your shovel added the value to their output. That, more or less, is the basis of capitalism. As time goes by, technology and methods improve, adding value, meaning we get more widget output per unit of resource input, and wealth increases.

There’s another way to make wealth though, which is easier: by cutting costs, or essentially extracting value. Cutting staff, for instance. That means you spend less money per shovel, meaning profits increase, for a while anyway.

The third way to make wealth is to borrow lots of money. The problem is, eventually you have to pay it back.

Value creation should be a long-term and sustainable wealth-generation technique; value extraction is a short-term, unsustainable wealth-generation technique. Borrowing to make wealth is probably the worst way, since it creates bubbles that burst.

I’ve been thinking about value vs wealth in the context of the global economic meltdown. I don’t have any answers at all but I am struck by the shape of the stock market curves for the past 40 years. Below is the S&P 500, between 1970 and 2009, a good proxy for the value of the economy.

S&P 1970-2009

It looks to me like there was a historically stable amount of value creation, reflected in the indexes, that for some reason in 1993/94 started to go a bit nuts. Two things drive it, I believe: low interest rates, meaning cheap debt flooding the market with money – corporate, personal, housing, financial; and increased global trade, namely with China, which kept prices and inflation low.

But it looks to me, based on this graph, that the wealth of the past 10-15 years was illusory, and that in fact the markets have dropped back to where they “should” be.

Does anyone have a better analysis of what happened in 1993/1994 when the whole thing started to go a bit nutso, in historical terms? I have a pretty surface understanding of financial policies, but this graph looks pretty telling to me.


  1. AJ Kandy AJ Kandy 2009-02-26

    I would add to the mix, the cost of energy. Throughout the 1970s and 1980s, oil prices remained relatively high due to OPEC and, depending on what sources you read, either ‘artificial’ scarcity from cartel activity, or genuine scarcity due to Peak Oil limits hitting the oldest oil-producing countries.

    What saved people’s bacon in the early 90s was the development of North Sea oil (for Europe) and Prudhoe Bay (for North America). This added greatly to the world’s known oil reserves, and as such deflated the cost of energy during the 90s. This, more than anything else, spurred the 90s boom, particularly in production homebuilding / suburban sprawl expansion, and also made transportation much cheaper — it’s what made ‘just in time’ delivery possible, as well as cutting a key cost in outsourced / overseas manufacturing.

    In essence, it seemed that energy was cheap and nearly limitless, removing barriers to growth, which encouraged irresponsible speculation. At the same time we got the Republican control of congress during that era, there were hard pushes for deregulation which passed.

    Unfortunately, those new oil reserves seem to be peaking even faster then the old supergiant fields (like Ghawar); therefore the world’s energy wealth is contracting, and deflating the speculative bubbles.

    Just a thought.

  2. Houssein Houssein 2009-02-26

    Maybe: low interest rates + flood of capital (mostly foreign) = incentive to take risk.

  3. Michael Michael 2009-02-26

    Great post Hugh, and though I don’t have a comprehensive answer to your question, I do have a comment on something that your graph demonstrates quite clearly – the parallels between the Enron crisis and what has happened in the past few months.

    Enron was fundamentally about two things: Enron execs who acted in bad faith throughout many of their dealings – AND the fact that the tool they used for their criminal activity was, essentially, to make up fake financial and investment instruments to move money around and make fake money with no underlying value.

    If you watch the (great) documentary “The Smartest Guys in the Room” it’s really clear – at least it was to me – that even if they hadn’t acted in bad faith, the financial instruments they invented (with the willing collaboration of both investment banks and rating agencies) were destined for failure.

    As I understand it, it’s precisely the application of this kind of “fake” financial instrument (but more broadly throughout the economy) that is at the heart of all the crap going on now.

    I wonder if “The Street” and more importantly financial regulators had learned the really important lessons from Enron if most of this could have been avoided – that would have been the correction to that era’s silliness, not the current crisis.

    That’s why for me this is fundamentally a political issue more than an economic one. Hoping that profit-motivated economic actors are going to be moderate is a recipe for disaster – a robust regulatory regime (which relies on strong political will) is essential to prevent the excesses.

  4. Hugh Hugh 2009-02-26

    @AJ: yeah, I was thinking about adding oil to the mix. definitely a factor, though the exact match to index curves is not so clear, see:

    @houssein: flood of capital (foreign or otherwise) is essentially “cheap debt” … but I don’t think it’s risk that’s the real problem, so much as unsustainable expansion of the economy. What’s puzzling to me is that the expansion came without significant inflation, which is usually the check on bubbles, for policymakers and buyers. So why were we able to have this huge expansion of “wealth” with little inflation, even with oil soaring to $150/barrel?

    Again, I suspect this has something to do with cost-cutting, and export of manufacturing jobs to low-wage countries, meaning in fact wealth was expanding significantly for the top tier of western society, but getting worse for the lower tier. So the inflation at the top was mitigated by cheaper prices from China, and loss of purchasing power at the bottom, that was not factored into inflation calculations.

  5. Houssein Houssein 2009-02-26

    Hugh, In think the assumption that the S&P 500 index is a good indicator of economic growth is not quite accurate.

    Try to compare the S&P index to the GDP historical data. They do not fit. GDP does not show the same kind of Stock Market bubbles. Bubbles are, by definition, caused by market speculation (and non rational risk taking).

  6. Hugh Hugh 2009-02-26

    @houssein: part of the reason for the GDP-S&P disconnect is that much of the economic activity generating increases in stock values happen outside of the US, even if the companies are listed on a US exchange. So I’d be curious to see global GDP vs S&P – I’d guess they are closer than US GDP vs S&P.

    But in this case the bubble was not purely speculation: the past 15 years saw significant increases in company profits as well.

    while the tech bubble was a value bubble (that is, stock value inflated well beyond traditional P/E ratios, often for companies that had NO profits), this last bubble was something different.

    And again, I think that the problem here is that profits were driven by borrowing money, and high amounts of leverage.

  7. Lindsay Lindsay 2009-02-26


    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.

  8. Hugh Hugh 2009-02-26

    @lindsay: i wonder though, what recent events would say about all that? would massive & unprecedented bank leveraging + low interest rates (both of which = lots of money flowing around) be a more compelling explanation?

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

  9. Felix Felix 2009-02-27

    Well, you might be onto something, but I do have a number of issues.

    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.

  10. AJ Kandy AJ Kandy 2009-02-27

    GDP also includes negative activity. I think the Genuine Progress Indicator might be more useful.

    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.

  11. Hugh Hugh 2009-02-27

    @felix: “Cutting costs means producing more with less, which means you’re increasing productivity or efficiency.” sometimes. sometimes it means that your bottom line looks fatter for a brief while (rewarded on the stock market, which thinks short term), and then you are left with less ability to create value in your company.

    “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?

  12. Hugh Hugh 2009-02-27

    @houssein: heh. looks like that article could use an update:
    “In 2000, according to statistics at the World Bank the market cap to GDP ratio for the U.S. was 153%, a sign of an overvalued market. With the U.S. market falling sharply after the dotcom bubble burst, this ratio may have some predictive value in signaling peaks in the market. However, in 2003, the ratio was around 130%, which was still overvalued but the market went on to produce all-time highs over the next few years.”

  13. […] In my post about the the stock market bubble(s) of the past 15 years, I asked what kind of policy shift happened in the 1990s to allow such a significant change in stock asset valuation. The answer comes from Niall Fergusson, in this fabulous (and scary) interview in the Globe: “Monetary policy evolved in a peculiar way in the 1990s towards de facto or de jure targeting of inflation, an increasingly narrow concept of inflation – core CPI. I thought it was a mistake at the time because it seemed to me crazy to ignore asset prices. Why differentiate? What’s the difference between pricing a loaf and pricing a house? Why do we care about one and not the other? In fact, we should probably care more about the price of a house than the price of a loaf, certainly in developed societies. I think there was a flaw in the theory there, that essentially you could call the Jackson Hole consensus. When the central bankers got together at Jackson Hole, the view that emerged from the debate in the late 90s was, we shouldn’t really pay attention to asset prices in the setting of monetary policy.” [more…] […]

  14. Felix Felix 2009-03-05

    Well, the economics I’ve studied doesn’t have a whole lot to say about the stock market, other than it’s hard to use it as a predictor or indicator of the health of the economy, and one reason is because it can be prone to bubbles and busts, systemically getting the price wrong. So it doesn’t say much about a soaring stock market other than it’s probably one of those cases. Economics, however, doesn’t really have a good bubble theory, although the Austrian school kinda does.

    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.

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