Friday's crack in the
, a 10% drop on top of 20% with the threat of more to come (an eventuality warned of
here), should put an end to talk about an inflationary wealth effect. No wealth. No effect.
But what was the wealth effect, anyway? In that bizarre speech at
on March 6,
put it this way:
...a rise in structural productivity growth, not surprisingly, fosters higher expectations for long-term corporate earnings. These higher expectations, in turn, not only spur business investment but also increase stock prices and the market value of assets held by households, creating additional purchasing power for which no additional goods or services have yet been produced.
Taken literally, this was pure nonsense. Productivity growth, reflecting
gains in technology and business organization, has no effect on expectations for
corporate earnings. Higher profit expectations cannot increase stock prices unless funds to purchase stocks are shifted
consumption, or borrowed from banks and brokers. And higher stock valuations have little effect on the current consumption of ordinary American households, since the stock holdings of the bottom 90% remain minor -- and half of all households own no stock at all.
But one should not dismiss Mr. Greenspan so abruptly. When he speaks in tongues, he is often speaking of something else entirely and perhaps of something not so easily spoken of. Is there perhaps something else to the "wealth effect"?
Of course! And we all know what it is, including several readers of this column who tried to persuade me, after my
last jeremiad, that "inflation is everywhere" in this economy. (Everywhere, I replied, but in the Chairman's speeches.) Most of them, I noticed, lived near the Silicon Valley.
The Tech Effect
The wealth effect is the tech sector. It is, or was, the Nasdaq bubble. It is, or was, the dot-com craze and the mechanism of the IPO.
How so? Simple. Consider the famous Internet model of business operations: Raise capital. Burn it. Grow your company. Cut costs. Go down the learning curve. Realize economies of scale. Drive your competition into the ground. And eventually, at the end of the rainbow, in the sweet hereafter, but not today or tomorrow, make an actual profit on actual sales. How many tech companies have been doing that in the past few years?
Many of them. The circumstances required it. Capital was cheap to raise, profits hard to come by. If you didn't burn, if you didn't grow, you would neither make a profit nor survive to fight another round.
And yet, every one of these companies met a payroll. And all their workers, all their managers, all their engineers and programmers and all of
families contributed to the great stream of spending that has made for the Long Boom. They were, in effect, converting enthusiastic investment into consumption expenditure through the mechanism of rising valuations. A wealth effect, if ever you saw one.
This wealth effect was charming. In contrast to past frenzies, in real estate or oil, this one enriched the nerds of American folk culture. It fostered a mass of amusing new products. And it promised, with eternal optimism, to change the way we all lived for the better -- a promise that was nice to hear even if it was rarely clear just how a search engine or a digital pager could actually accomplish any such thing.
The Doomed Boom
And now it's coming to an end. Over six to eight months the bubble accelerated the financial demands on the New Economy far beyond the capacity of the companies to deliver. More money came in than the sector could handle. Suddenly, promises that might have matured over years (maybe) came due in months. The steady optimists among investors were elbowed aside, the rush took over, and the boom was doomed.
This didn't have to happen. It wasn't inevitable. It was the perfectly predictable product of Mr. Greenspan's indifference to speculation on margin, combined with his colleagues' feckless pursuit of higher interest rates. Feed a bubble. Pop a bubble. Then, "What, who, me?" This is what we are fed with. We cannot have discipline so we must have pain.
And so, what does the crashing of the Nasdaq mean? By itself, in the greater scheme of things, not very much. Total employment in the IT sectors is not above 10 million, generously defined. In a good deep slump, with bankruptcies galore, how many jobs will go down? One million? Two?
This would be a shame, but there are 130 million working Americans, most of them in companies that do make a profit. For the same reason that the wealth effect did not produce inflation, even a stiff shakeout will not produce a recession. By itself, the sector is too small.
But notice the qualifier.
. The Old Economy is doing fine, but any number of things could go wrong, and quite soon. Fiscal drag (the budget surplus is too big). High interest rates. High oil prices. A squeeze on credit that might come from banks reacting to losses on brokerage loans.
We shall now see whether Mr. Greenspan can react to the plain consequences of his own dangerous policies and change them, protecting the rest of us before we follow the tech sector down.
James K. Galbraith is author of Created Unequal: The Crisis in American Pay (Free Press, 1998) and director of the University of Texas
Inequality Project. A professor at the University of Texas at Austin and senior scholar at the Levy Economics Institute, he worked for many years on the staff of the House Banking Committee, where he conducted oversight of the Federal Reserve. He welcomes your feedback at