As my late friend and eminent economist Herb Stein often suggested: If a trend cannot continue, it will stop. What will stop the wealth-induced excess of demand over productivity-expanded supply is largely developments in financial markets.
That process is already well advanced. For the equity wealth effect to be contained, either expected future earnings must decline, or the discount factor applied to those earnings must rise. There is little evidence of the former. Indeed, security analysts, reflecting detailed information on and from the companies they cover, have continued to revise upward long-term earnings projections. However, real rates of interest on long-term BBB corporate debt, a good proxy for the average of all corporate debt, have already risen well over a full percentage point since late 1997, suggesting increased pressure on discount factors.3 This should not be a surprise because an excess of demand over supply ultimately comes down to planned investment exceeding saving that would be available at the economy's full potential. In the end, balance is achieved through higher borrowing rates. Thus, the rise in real rates should be viewed as a quite natural consequence of the pressures of heavier demands for investment capital, driven by higher perceived returns associated with technological breakthroughs and supported by a central bank intent on defusing the imbalances that would undermine the expansion.
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