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CIAO DATE: 8/01
Public Policy Bears on the Markets
On The Issues
May 2000
The influence of economic policy on stock prices is evident in both the recent correction in the high technology sector and the broader bull market that started in the early 1980s. If that bull market is to continue, government will have to produce efficiency and accountability in its two largest areas of spending—Social Security and medical care.
There is an old Wall Street adage that one shouldn't confuse investment genius with an extended bull market. The same might be said of economic policy. Given a seventeen-year run that has driven indexes to extraordinary heights, it is worth considering why the market chose the past few weeks to undergo a major correction.
Vice President Al Gore's analysis was that "markets go up and markets go down." It's an insight that's hard to argue with, but it implies that there is no link between public policy and the market's sudden reversal. But the facts show the tone of public policy shifted during the past few weeks, and that the market noticed. Politics is taking its toll on prosperity, while areas in need of government reform continue to be neglected.
The Nasdaq Stock Market began its decline during the second week of March, when biotechnology stocks suddenly plunged. The cause was a statement issued on March 14 by President Clinton and British prime minister Tony Blair, asserting that knowledge about the human genome should be made available to all of mankind. Of course, what belongs to all of mankind cannot be easily patented, and thus the products the biotechnology industry is developing didn't seem as profitable to investors. The Nasdaq Biotech Index is down about one-third since then.
Then on April 3, Judge Thomas Penfield Jackson issued his Microsoft ruling. That day and the next were among the most volatile in stock-market history. The Nasdaq swung as much on those two days as did the Dow during its famous 1987 crash. Whatever the legal merits of Judge Jackson's ruling, it created massive uncertainty for the fastest-growing segment of our economy.
In both these cases investors were confronted with the realization that political forces might deprive them of future earnings. The multiples built into today's stock prices presuppose the kind of high earnings that successful innovators get from dominant market positions. It may be that investors had underestimated the long-term political and legal risks to those profits. But that misperception is now being corrected via the market.
The market got a third shock on April 14, when the March consumer price index showed a 0.7 percent rise in the overall index and a 0.4 percent increase in the core rate (which excludes food and energy) over the previous month. While the equity market has largely recovered from this shock, bonds have not. The markets got a further reminder during the last week of April, when the Commerce Department reported that both the gross domestic product deflator and the personal-consumption deflator rose faster than at any time in at least five years.
A few old-timers might find all this reminiscent of the 1970s, when profits were described as obscene, capitalism was viewed as evil, and inflation was allowed to run free. Those days came briefly back to life during April's World Bank and IMF meetings, when an assortment of left-leaning groups staged demonstrations in Washington against global capitalism. Investors, who recall those years as a time of consistent negative real returns, would greet any sign of their return negatively.
Of course, the United States isn't going to make any sudden return to that era. The Federal Reserve has been taking some unpopular preemptive action to head off the inflation threat and will continue to be vigilant. The private sector has also shown enormous increases in productivity, which are here to stay.
Policy Successes and Failures
This seventeen-year bull market has resulted from the creativity and energy of the nation's entrepreneurs. But three major public-policy successes allowed that energy to be unleashed. First, the defeat of inflation in 1981 and 1982 allowed a shift in resources away from inflation hedges and into real returns. Second, the defeat of the Soviet Union allowed us to reduce defense expenditures by 2.5 percent of GDP—equivalent to $250 billion today. This permitted a sharp reduction in the federal deficit and in public demands for credit. Third, a shift away from high taxes and regulation allowed markets to send their signals relatively unimpeded.
Unfortunately, these policy triumphs and the economy's success have allowed our national leaders to become complacent about that portion of the economy for which they are actually responsible. This complacency not only fosters a reckless willingness to tinker politically but creates festering lumps of inefficiency. If we want the bull market to continue, we must address these problems.
Today the largest single program in government is Social Security. Last month Mr. Gore laid out his position on reform: "If it ain't broke, don't fix it." Mr. Gore should know better. The Social Security system has a massive long-run actuarial deficit.
According to the Social Security Administration, the unfunded liability of the system rose from $7.4 trillion to $8.8 trillion during Mr. Gore's vice presidency. This stands in sharp contrast to the enormous improvement in the private-sector retirement system. Mr. Gore's solution to Social Security's problems is to "shore it up the way we always have." This has traditionally meant higher payroll taxes. For the system to continue to meet its current demands, payroll taxes would have to rise to 19 percent from the current 12.4 percent.
Mr. Clinton's proposed solution, meanwhile, is to issue more bonds to the Social Security trust fund without any reform. Servicing this bond issuance would, in effect, substitute a 25 percent hike in personal income taxes for the payroll tax hike. Either way, the cost of avoiding reform would have huge implications for the long-run performance of the economy and the markets.
Or consider medical care, the second-biggest area of government spending. Again, the government's inefficiency is manifest. From 1992 to 1998, government health-care spending rose 50 percent faster than private-sector spending. There is little to show for the increased spending. The number of uninsured Americans has been rising by one million a year—a total increase of more than 20 percent since 1992. Among the elderly—the group supposedly most protected by government—out-of-pocket health-care spending is far higher than it was eight years ago.
Again, the private sector is ultimately going to bear the burden. The tax revenue generated by the private sector is what funds the explosion in public health-care costs. But the government's failure to carry its load means a drain on the savings of the elderly and increased demands on the privately insured to cross-subsidize the uninsured.
Public policy has neglected the national interest in yet other ways, all to the detriment of long-term market
performance. As tax rates on the nation's savers have risen sharply, the private-sector saving rate has declined precipitously. We are more dependent on imported capital today than at any point in the twentieth century. Yet reforms to our tax system designed to reverse this trend are considered "risky."
We have made no effort to increase energy independence during the last decade and as a result are at the mercy of the Organization of Petroleum Exporting Countries. We have sharply increased spending on public education but have refused to hold schools accountable for their performance. The result has been wasted money and wasted minds.
The market's recent performance shows that public-policy actions do affect the behavior of the market on a day-to-day basis. We can point to concrete policy changes made during the 1980s that made today's market performance possible. Can we point to any public-policy changes of recent vintage that will sow the seeds for growth in the next decade?
Lawrence Lindsey holds the Arthur F. Burns Chair at AEI. His a campaign adviser to Gov. George W. Bush. An earlier version of this article appeared in the April 21, 2000, issue of the Wall Street Journal.
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