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May 15, 2005

                                                              Federal Reserve Bank of Cleveland

effect is unlikely the channel that          “copy” could be sold on the stock mar-         ■     Stock Market Bubbles and...
To estimate the size of the effects, con-    The forces that perpetuate a stock mar-
sider the following. From 1929 to the...
Paul Gomme is an economic advisor at the
Federal Reserve Bank of Cleveland.

The views expressed here are those of the
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Why Policymakers Might Care about Stock Market Bubbles


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Transcript of "Why Policymakers Might Care about Stock Market Bubbles"

  1. 1. May 15, 2005 Federal Reserve Bank of Cleveland Why Policymakers Might Care about Stock Market Bubbles by Paul Gomme O n the face of it, it’s somewhat perplexing that variations in the stock insulate the macroeconomy somewhat from stock market fluctuations. This Commentary makes a case for market should have effects on the macro- If there isn’t much of a link between the Fed action in the event of a stock economy more generally. After all, on stock market and the supply side of the market bubble. Because stock market each side of a stock market transaction is economy (the ability of the economy to prices serve as a signal to business a buyer and a seller; the sale of stock by produce goods and services), then per- managers to invest, bubbles can mis- one individual corresponds to the trans- haps there is one between the stock mar- lead managers into investing when it fer of ownership of a small piece of a ket and the demand side (the influences is not profitable. The overinvestment, firm to another individual. Following on demand for goods and services). Two likely candidates present themselves: which becomes apparent after the such a transaction, the firm can continue consumption and investment. The next bubble bursts, can lead to a period of to produce the same goods and services since all the employees still work for the section briefly examines the consump- low investment, which can cause a firm, the firm still owns the same plant tion channel and finds that it simply isn’t recession. Policymakers may wish to and equipment, and the particular ways big enough. We then examine the more step in to end a bubble before stock of utilizing these inputs are still known. promising channel of investment. We prices get too far out of line relative consider a particular theory of invest- to their fundamentals. But the stock market’s ups and downs ment (known to economists as Tobin’s can have very real, if not direct, effects q), but the crux of the argument is that on the macroeconomy. Stock market stock market prices serve as a signal to bubbles are a case in point. The firms’ managers to buy new investment times GDP to 1 times GDP. Such a fall inevitable crash that follows a bubble goods. We will see that a stock market in market wealth is estimated to have has the potential to cause recessions— crash can very quickly lead to a reduc- caused a reduction in consumption of the Great Depression being the worst- tion in investment, and so a recession. 0.36 percent of GDP. (This figure is cal- case example of that connection to date. Further, we will see that such invest- culated using a reasonable estimate of The mere possibility of repeating an ment-triggered recessions may be the degree to which U.S. consumers episode so destructive warrants policy- long-lived. change their consumption when their makers’ interest in the behavior of the wealth changes—known as the “mar- stock market, even though the link ■ Wealth Effects ginal propensity to consume out of between the stock market and the One reason that fluctuations in stock wealth”—of 4 percent. That is, for every macroeconomy may not be well under- prices may affect the macroeconomy is $100 decline in wealth, the estimate sug- stood. Indeed, there is continuing that individuals who hold stocks, either gests that U.S. consumers lower their debate within the economics profession directly or indirectly (for example, consumption by $4.) Put differently, we over the exact causes of the Great through mutual funds or pension plans), would expect GDP growth to be 0.36 Depression, as well as the factors that feel poorer when the stock market falls. percentage points lower than it would led to its severity and duration. We This wealth effect causes people to cut have been had the stock market capital- should also keep in mind that the link back on their consumption, a major ization stayed at 1.9 times GDP. between the stock market and the component of aggregate demand. macroeconomy is not very tight. As While 0.36 percentage points of growth Paul Samuelson quipped, the stock mar- How big might these wealth effects be? over 10 quarters is nothing to sneeze at, ket has predicted nine of the last five Consider what happened during the it certainly is not a disaster. In fact, it recessions. Perhaps the lack of a tight stock market decline that began in the would be difficult to identify a 0.36 per- connection between the stock market first quarter of 2000 and ended in the centage point change in growth in light and the macroeconomy is a positive third quarter of 2002. Over this period, of the large and routine fluctuations in development, particularly if we think the combined market capitalization of GDP growth during a business cycle that policymakers have managed to the NASDAQ and NYSE fell from 1.9 expansion. In other words, this wealth ISSN 0428-1276
  2. 2. effect is unlikely the channel that “copy” could be sold on the stock mar- ■ Stock Market Bubbles and causes stock market crashes to lead ket for $300 million (the current market Investment to recessions. value of the firm), then $50 million in A problem arises when “irrational exu- additional value would be generated. In berance” leads to a “bubble” in stock ■ Tobin’s q other words, by spending only $250 mil- market prices—that is, when the stock We now turn to a more promising lion, the replicated firm would have a market prices of firms rise above their channel between the stock market and market value of $300 million, so that the fundamental prices, as dictated by the the macroeconomy: investment. Some investment would yield a substantial present value of firms’ current and economists argue that stock market return and so should be undertaken. future dividends. In this case, many— prices provide information that business perhaps even all—firms see their q rise managers use to make investment deci- ■ The Connection to the above one. And according to q theory, sions, and when the market is Macroeconomy firm managers will increase their invest- overvalued, it leads to overinvestment. The story told by Tobin’s q is, perhaps, ment in capital goods. This is the first James Tobin expressed this idea in overly stylized. For example, it may be problem: Owing to the stock price bub- his “q theory” of investment. It’s only difficult for firms to replicate them- ble, firms are buying capital goods when one way the stock market might affect selves. The market value of a firm they “shouldn’t be.” investment and, in turn, the macro- includes the value of its intangible economy, but it will serve to illustrate assets—things like patents, copyrights, The second problem arises when the how the link might work. and trademarks. In this case, we would bubble pops. If firms’ profitability is expect to see average q be greater than more or less unchanged, then stock To start, Tobin defines a “marginal q” one even though there is no compelling prices should return to their previous for a firm as the ratio of the market reason for the firm to increase its invest- fundamental levels. But during the bull value of new additional investment ment activity. This example points out market, firms acquired lots of capital goods to their replacement cost. The that what we would really like to know goods (after all, their qs were larger than reason q is of interest is that only when is marginal q, but what we observe is one). As a result, the replacement cost of q is greater than one should the firm average q. firms’ assets has increased, thereby dri- invest (purchase new capital goods). To ving down their average qs. Conse- understand why q being greater than Nonetheless, the basic intuition underly- quently, we would expect that firms one is the crucial relationship, consider ing Tobin’s q is compelling: Changes in would curtail their purchases of invest- the following example. Suppose that a stock prices should serve as a signal to ment goods for some time. firm has an investment project that costs firms’ managers. Consider what should $1 million to implement, and this pro- happen when a firm discovers a process Of course, there’s a complication in ject will increase the market value of that makes it more productive, or equiva- that firms have more capital goods at the firm by $1.5 million. In this case, q lently, allows it to produce its goods at a their disposal and so can produce more equals 1.5, and proceeding with the pro- lower cost than its competitors. Realiz- goods. Each firm now generates more ject generates a net gain of $500,000. ing the competitive advantage now held profits, and so the fundamental stock In fact, only when q is greater than one by this firm, investors on the stock mar- market price of the firm should be will a project generate a net gain for ket will bid up the price of the firm. This higher. But these investment projects the firm. run-up in the firm’s stock price then have relatively low returns; if they serves as a signal to the firm’s managers didn’t, firms would have made these While the replacement cost of new to increase their purchases of capital investments before the stock market capital goods is known, figuring out goods. Through the lens of Tobin’s q the- bubble. So while each firm can generate how the stock market will value the ory, the firm’s q would initially equal more profits, now and in the future, the firm with this new investment is prob- one. Following the discovery of the new increase in profits is smaller in percent- lematic. Consequently, the related process, the firm’s q would rise above age terms than the increase in the firm’s “average q” is more typically used; it is one as its stock price increases. Above, assets. Consequently, the contribution defined as the ratio of the stock market we saw that when q is greater than one, it of these additional capital goods still valuation of the firm to the replacement is a signal to the firm to increase its pur- constitutes a drag on average q. Firms’ cost of its assets. Notice that if average chases of investment goods. purchases of investment goods will, q is greater than 1, then investors’ valu- then, be low. ation of the firm exceeds the cost of its Of course, the stock market prices of assets. Again, average q being greater other firms in the industry should fall ■ Does It Matter? than one is the key relationship that because they are now at a competitive dis- Are policymakers right to be concerned signals what we would expect to advantage, and their qs will presumably about the stock market? More impor- happen to investment in the future. be driven below one. The fall in these tantly, if the stock market is character- Consider a specific example: Suppose other firms’ stock prices (such that their q ized by a bubble, should policymakers the firm has a market value of $300 is less than one) signals that these firms react? While a bursting bubble will cer- million, while the replacement cost should not be buying investment goods. tainly affect investment, if the investment of its assets is $250 million; then its effects are small, then there is little for average q equals 1.2. Now, suppose that So, in the normal course of events, stock policymakers to worry about—at least the firm could create an exact replica market prices (firms’ qs) send the appro- from the macroeconomic perspective. of itself, at a cost of $250 million (the priate signals to firms: Invest only if q is replacement cost of its assets). If this greater than one.
  3. 3. To estimate the size of the effects, con- The forces that perpetuate a stock mar- sider the following. From 1929 to the ket bubble are somewhat better under- present, private fixed nonresidential stood than the causes of a bubble. Even investment (the relevant measure for the those investors who recognize that the q calculations) has averaged 9.5 percent market is experiencing a bubble will of GDP; if we consider only the rationally participate in the bubble. post–World War II period, the average After all, stock market prices are rising, rises to 10.5 percent. So, following the and positive gains can be earned while bursting of a stock market bubble, sup- the bubble lasts—that is, so long as pose that investment falls from 10 per- there is some other investor willing to cent to 0 percent (the lower bound for buy your stock at an “inflated” price. It investment). Such a fall would precipi- is in this context that policymakers may tate a 10 percent fall in GDP, and so a wish to step in to end the bubble before 10 percentage point fall in GDP growth. stock prices get too far out of line rela- Now we’re talking about recession- tive to their fundamentals. sized changes in output. Such a fall in investment—and so GDP—could easily occur very quickly. Tobin’s q theory would suggest that the fall would occur the instant that firms’ qs fall below one, but given the fact that many investment projects take sev- eral quarters to complete, the fall in investment would likely be somewhat more gradual. The period of low investment following a stock market crash is likely to be prolonged. After all, during the bull market preceding the crash, firms were acquiring lots of capital goods. After the crash, firms find themselves with more capital than they “need”—a situation often referred to as “capital overhang.” Over time, this “excess” capital will be worked off through both economic growth and depreciation of firms’ exist- ing capital. But this process can be expected to take quite some time. ■ Conclusions This Commentary has given a potential rationale for policymakers to monitor the stock market. However, it is only when there is a bubble—when stock prices deviate from their fundamental values—that trouble can arise. During a bubble, firms are undertaking invest- ments that they “shouldn’t.” When the bubble pops and stock market prices return to their fundamental prices, we can expect a long period of low invest- ment, and likely recession.
  4. 4. Paul Gomme is an economic advisor at the Federal Reserve Bank of Cleveland. The views expressed here are those of the author and not necessarily those of the Federal Reserve Bank of Cleveland, the Board of Governors of the Federal Reserve System, or its staff. Economic Commentary is published by the Research Department of the Federal Reserve Bank of Cleveland. To receive copies or to be placed on the mailing list, e-mail your request to or fax it to 216-579-3050. Economic Commentary is also available at the Cleveland Fed’s site on the World Wide Web: research. We invite comments, questions, and sugges- tions. E-mail us at PRSRT STD Federal Reserve Bank of Cleveland U.S. Postage Paid Research Department Cleveland, OH P.O. Box 6387 Permit No. 385 Cleveland, OH 44101 Return Service Requested: Please send corrected mailing label to the above address. Material may be reprinted if the source is credited. Please send copies of reprinted material to the editor.