Part II: WSJ Letters:Federal Spending Can Hurt Market
Sept 28, 2001
Burton G. Malkiel's otherwise superb analysis of the stock market in the aftermath of the Sept. 11 terrorist attack ("Don't Sell Out," editorial page, Sept. 26) could benefit from the warning in your editorial "A War Economy" the same day. Your editors expressed concern over the possibility that Congress will use the tragedy to engage in massive non-defense federal spending increases.
In a study done with Lowell Gallaway for the Joint Economic Committee of Congress, we demonstrate (on the basis of analysis of two decades of data) that not only do stock market averages track remarkably well with inflation levels/interest rates, but also with the size of government. When federal spending as a percent of total output grows, the stock market falls -- a lot. The rise in market averages in the five years after 1994 reflects in significant part the decline in federal spending as a percent of GDP, as the political environment temporarily turned against deficit-financed spending increases. Similarly, the pre-September 11 decline in equity prices partly reflected the anticipation that the decline in the relative size of government had stopped, given indications of a renewed Congressional spending spree in the past year or two.
The adverse impact of government on equity prices is twofold.
First, by increasing its command over resources, bigger government means squeezed profits arising from higher taxes (if tax financed), or higher interest rates and/or inflation (if debt financed).
Second, in a very real sense, the private sector is on average, dollar for dollar, more productive than the public sector, as the former faces market discipline in its decisions while the government does not. Aggregate productivity falls when the government crowds out private activity.
If Sept. 11 means massive increases in federal spending for illegitimate ("fiscal stimulus" via increased domestic spending) as well as legitimate (e.g., protection of human and physical capital assets) reasons, it will raise the risk premiums associated with private investment activity, dampening the market.
The case for further tax cutting,advanced by some using
Keynesian-style arguments on the need to stimulate consumer
spending, is actually better advanced on the ground that
tax reductions raise the political costs to
members of Congress of engaging in a wholesale
spending spree.
Richard Vedder
Distinguished Professor of Economics
Ohio University
Athens, Ohio |
