Why a Crash Wouldn't Cripple the Economy

Thursday, October 30, 1997

Human capital is the most important type of wealth in the United States and other modern nations. This crucial fact is being neglected in assessments of the macroeconomic consequences of a possible crash in stock prices .

Wealth in the form of human capital consists of present and future earnings because of education, training, knowledge, skills, and health. Since wages and salaries account for over 75 percent of the national incomes of developed countries, it should be no surprise that human capital is estimated to be three to four times the value of stocks, bonds, housing, and other assets. For most employees, human capital and housing are their only important wealth since stocks and bonds are concentrated in the portfolios of the rich and in pension assets of retired persons.

Human capital's dominant position in aggregate wealth implies that even large changes in the market value of stocks and other assets will not greatly affect the behavior of most people unless the value of their human capital also changes. In particular, stock crashes alone should not cause serious recessions in economic activity.

Luxury Losses

The last crash in U.S. stocks occurred in October 1987, after prices had been rising for about a year. On one day in that month, prices fell by more than 20 percent, one of the largest declines in American financial history. There was panic in the media and Washingtonãbut not among consumers and companies. The only noticeable effect of this meltdown in stock values on the real economy was a large fall in employment in the securities industry and weakened demand for expensive cars, yachts, jewelry, art, and other luxury items. After the widespread predictions of another 1929-style economic collapse did not materialize, stocks also recovered to their precrash levels.


The 1987 plunge lopped some one trillion dollars off stock values, which reduced financial wealth by about 8 percent. But since this lowered total wealth by less than 2 percent, it could not have a major impact on the economy unless it eroded confidence in the earning power of human capital. In fact, I used the stability of human capital values to correctly predict shortly after the crash that there would be only a small overall effect on the economy (BusinessWeek, November 9, 1987).

That experience is fully applicable a decade later. World stock markets have surged during the past two years; U.S. stocks have risen by more than 50 percent since the current phase of the bull market began almost two years ago. Still, most Americans are only slightly better off, though the increased financial wealth of a small number of rich individuals has fueled a revival of the markets for art and other expensive goods.

Dangerous Talk

The extended bull market and rising ratios of stock prices to corporate profits have alarmed a growing number of officials and analysts, including Federal Reserve chairman Alan Greenspan and the highly successful investor Warren Buffett. Greenspan warned that prices have been bid up by "irrational exuberance," and he even implied that a crash might propel the global economy into a serious depression. Although past experience indicates that stocks do severely contract at irregular intervals, the market to a large extent listens to its own drummer. Neither Greenspan nor anyone else can predict when a crash might happen. Although price earnings ratios are high by historical standards, even bigger ratios in the past have frequently been followed by further rises in stock prices for extended periods.

Greenspan's comments are dangerous because asset prices are sensitive to expectations and confidence about the future. Government officials should not try to tamper with this confidence since pessimism induced by bearish comments by leading officials may feed on itself and spread among investors. Adam Smith cautioned two hundred years ago that government planners should not have the hubris to believe that they can manipulate the economy the way a grand master manipulates his chess pieces.

But even if stocks do crash, the good news is that this will not have a big effect on aggregate employment and output as long as the value of human capital is not greatly affected. In particular, even a 25 percent fall in the stock market that melts overall equity values by several trillion dollars reduces the total wealth of the United States, inclusive of human capital, by less than 3 percent.

The importance of human capital is frequently recognized in a general way by politicians and others. But it is still commonly overlooked when analyzing the broader economic implications of stock market booms and busts.