Tuesday, April 4, 2000

Over the last three years, the high technology-dominated Nasdaq stock exchange has seen growth rates of 86 percent, 40 percent, 22 percent, and 23 percent annually from 1996 through 1999.

Through the first quarter of this year, it is up 12.4 percent while the Dow is down 5 percent. Such dramatic performance and stark divergence earlier prompted Newsweek columnist Robert Samuelson to cite John Maynard Keynes’ analogy and liken the Nasdaq to a casino. Such spectacular growth (and such a spectacular decline, as witnessed yesterday) surely raises questions is this the irrational exuberance of which Fed chief Alan Greenspan has warned?

An underlying suspicion is that the Nasdaq’s rapid increase in valuation represents speculation run amuck to the detriment of legitimate investment. Certainly the Nasdaq has experienced tremendous capital appreciation over the last few years. Yet this fact by itself hardly proves the point that its increase either has been divorced from real economic factors or that such a rise is detrimental. Rather, it is many Nasdaq doubters’ implicit question What should instead be the proper method for distributing capital in the American economy? that should cause concern.

It is not the Nasdaq alone that is rapidly increasing. Historically, all stocks are doing extraordinarily well. From 1966 to 1997, all stocks gave a real rate of return of 6 percent. However from 1982 to 1997, they have given a real rate of return of 12.8 percent. Thus, it is quite possible to discern different patterns within overlapping time frames. Focusing on the Nasdaq’s last four years’ performance does just that. From the Nasdaq’s inception in 1971 through 1994, it experienced a nominal average annual growth rate of 8.5 percent in comparison, all stocks produced a growth rate of 8.4 percent from 1802 through 1997.

The Nasdaq represents not a cross-section of American business but a specific segment: the area with the most rapid and arguably the greatest potential growth. It is also the one in which the United States is far and away the world’s leader. It is not just America’s leading industry, but the world’s that is centered in the Nasdaq. Unsurprisingly, such leadership should be reaping rather dramatic returns.

Nor has this been the overnight phenomenon. Investment in information technology has been going roughly as long as the Nasdaq itself. Yet for years, it was an axiom of economic analysis that large “IT” investments were not yielding commensurate returns. Apparently they now are. As a result, productivity, which had existed in the “one percents” in every year of this decade (except the post-recession rebound year of 1992), was 2.9 percent in 1996, 2.2 percent in 1997, 2.8 percent in 1998 and 2.9 percent in 1999. It is logical that big returns would follow such dramatic results and potential.

It is also important to examine the comparative returns in other investments. Of course, the most common counterpoint to stock investment is bond investment. It is not coincidental that general stock appreciation has followed a dramatic decline on bond yields. In December 1980, stagflation had driven interest rates on the 30-year Treasury bond to 21.5 percent. Today that bond yields approximately 6.0 percent.

Finally, we must focus on the demand side of the equation: the source of the wealth driving Nasdaq prices. At home, Baby Boomers, America’s largest and wealthiest age cohort, are now in their top earning years their time to fund retirement, children’s education, etc. This massive amount of cash has to go somewhere. Abroad, overseas investors have been weathering recent economic setbacks in Asia, Latin America and Russia.

In short, the Nasdaq represents the world’s leading industry. It is giving strong evidence of its economic potential. This potential is greater than either that of the steam or internal combustion engines. America is in fact writing history electronically. This industry is centered in this country, which gives Americans an inside track on investing in it. America, with an economy more than twice that of the world’s second-largest, has simultaneously seen its largest age group reach its greatest earning capacity and has experienced a rapid decrease in the return on alternative investments.

Nothing in this scenario smacks of speculation. It represents not a repeal of economic laws but rather their response to a coincidence of positive economic factors.

This does not mean speculation doesn’t exist in the Nasdaq or any stock market. Certainly it does. Yet this does not detract from their real economic role of capital allocation. And it is to this essential role that Keynes’ casino comparison presents a danger.

To those discerning a problem in the Nasdaq’s recent growth, there follows a tacit question: What is the alternative? Keynes should remind us of an ominous answer. For two generations Keynesian thinking, that governments could better manage a society’s wealth than the society’s private workings, held sway. It was only by freeing ourselves from this mindset and its consequences witness the earlier cited stagflation resulting from attempts to control the economy through the money supply that the unprecedented economic growth we have experienced for the last 20 years has been possible. The worst lesson we could take from the Nasdaq’s increase would be that there should again be a government attempt to control the allocation of capital.

J.T. Young is the deputy chief of staff for the U.S. Senate’s Finance Committee.

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