[Oh, ye of little faithlessness. Yale economics professor Robert Shiller, author of _Irrational Exuberance_, had an interesting column relevant to this topic in yesterday's NY Times (posted below). Particularly noteworthy was his comment, "We should greatly expand the number and variety of securities, and markets for them, to allow people to protect themselves against major economic risks." I'm sure there's a catch in what he proposes along these lines, but -- despite my instinctual aversion to the marketplace -- I have to say the suggestion he lays out is thought-provoking.]
"Wealthy Market? Yes. Healthy? Wise? No."
By Robert J. Shiller
(Robert J. Shiller's "Irrational Exuberance" ends with a chapter on the broader consequences of an overvalued stock market, and some of his policy prescriptions. This article is based on his conclusions.)
By historical standards, the United States stock market has soared to extremely high levels. Yet if the history of high valuations in the market is a guide, the public may be very disappointed with the performance of the stock market in coming years.
By 1999, the Dow Jones industrial average had more than tripled in five years. But personal income and gross domestic product rose less than 30 percent, and almost half this increase was because of inflation. Corporate profits rose less than 60 percent. The size of the stock market's gains, therefore, appear to be unwarranted, and unlikely to persist.
How we value the stock market influences major economic and social policy decisions that affect not only investors but also society at large. If we exaggerate the value of the stock market, then we may invest too much in business start-ups and expansions and too little in infrastructure, education and other forms of human capital.
If we think the market is worth more than it really is, we may become complacent in funding our pension plans, in maintaining our savings rate, in legislating an improved Social Security system and in providing other forms of social insurance. We might also lose the opportunity to use our improving financial technology to devise new solutions to the genuine risks that we face -- to our homes, cities and livelihoods.
It is a serious mistake for political and business leaders to acquiesce in such high stock valuations. All of our plans for the future, as individuals and as a society, hinge on our perceived wealth, and those plans can be thrown into disarray if much of that wealth evaporates tomorrow.
If over some part of the first decade or so of this century, American stock markets follow an uneven downward course -- back, let us say, to the levels of the mid-1990s or even lower -- then individuals, foundations, college endowments and other beneficiaries of the market are going to find themselves poorer, in the aggregate, by trillions of dollars. Even if the market only stagnates, then, with a dividend yield having fallen to a little over 1 percent, these investors may find that there is virtually no return to stock market holdings.
Investors should therefore decrease their reliance on the growth of American stock market values in their economic decisions. In investments, they should diversify more broadly into other assets. Individuals should consider sharply increasing the amount of income that they allocate to such diversified investments, thereby creating more wealth for their retirement, for their children's education and for charity.
Colleges and foundations with endowment funds invested in the market should consider, when possible, substantially lowering their payout rates. This conclusion stands in sharp contrast to some recent recommendations that they raise their payouts and spending.
Pension plan executives should come out much more strongly against putting so much into the stock market. Instead, they should recommend greater diversification, especially into safe investments like inflation-indexed government bonds.
It would also be a serious mistake to adopt the proposed policy of replacing the current Social Security system and its guaranteed benefits with a defined contribution plan -- much like a 401(k) -- invested in the stock market, or even with a plan offering a choice of investment categories.
Such plans would replace the current commitments to the elderly with a hope that financial markets will do as well as in the past. Adopting such ideas when the market is near a record high relative to fundamentals would be an error of historic proportions.
Ideally, Social Security should work like true social insurance. Higher payments should be made to retirees with lower incomes, and both benefits and contributions should be indexed to national income.
We should greatly expand the number and variety of securities, and markets for them, to allow people to protect themselves against major economic risks. The stock market today is limited to trading securities that are claims on the profits of corporations.
The new international markets that I and my business colleague Allan Weiss call macro markets would include markets for long-term claims on national incomes for each of the world's major countries, for long-term claims on the incomes of specific occupational groups and for currently illiquid assets, like single-family homes.
People could then take short positions corresponding to their own incomes, whose value would rise if incomes in their profession fell. They could also invest in a truly diversified global portfolio around the world. A doctor in Des Moines could take a short position in medical incomes and a short position in expensive Des Moines single-family homes, thereby effectively insuring against risks to both sustenance and shelter.
At the same time, the doctor could buy securities linked to incomes around the world and to real estate around the world. World incomes and real estate values are inherently more stable than individual or regional values.
These macro markets could be vastly larger than any existing markets and far more numerous in the risks they allow people to diversify. Individuals' use of these markets could be helped by new retail products, like home equity insurance, or pension plan options, with cash flows that moved opposite from home values or wages.
These new markets could not only help counter over-investment in the stock market, but could also moderate the way people flock to trendy careers or start businesses in certain states, erroneously thinking they will be guaranteed much higher incomes.
Other jobs and regions, meanwhile, are left wanting. The creation of such markets would help us discover the unknown prices of many assets. No one today knows what the American economy's potential growth is worth, nor does anyone know what a medical career is worth, since there are no markets for them.
There appear to be speculative excesses in career choices and business locations that are analogous to the speculative bubbles we see in financial markets, as countries go through waves of optimism or pessimism about their own economies. Creating markets for claims on income flows will open up one nation's markets to the generally sobering influence of the rest of the world.
Creating the macro markets would also result in a fundamental attention shift, away from the risks of the stock market only to the greater risks to our livelihoods. Although one would still expect speculative bubbles in the macro markets, the diversity of investment opportunities and the attention focused on fundamental risks by these markets around the world ought to be generally stabilizing to our economies and our lives.
For policy makers, the problems posed by occasional speculative bubbles are deep. But we should not let these problems discourage us from radically improving our social insurance programs and financial markets to allow us to protect against the economic random events that wantonly jostle our individual standards of living today.
[end]
Carl
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