The collapse of the hot sectors has also pulled down the stocks of brokerage houses and banks that have been cheerleading for and financing those sectors. Finally, the contagion will spread to more basic stocks such as Home Depot, whose shares dropped sharply after announcing an earnings disappointment in mid-October.

The collapse in 2000 of the hottest sectors of the stock market will probably spread to other sectors and could well cause a U.S. recession next year and possibly a global recession. Even though the broadest stock indexes are "only" down 10 percent so far this year, a flat or modestly lower broad stock market is far from what U.S. households and businesses expected at the start of the year. Those expectations drove spending and borrowing to levels that were imprudent, because they required higher stock prices to be viable. The result of such imprudence will be sharply lower investment and consumption spending, probably starting by early next year.

The negative effects of the sharp drop of demand will be compounded by a contraction of credit, whose extension has been predicated upon ever-rising stock prices. That the credit shrinkage is already underway has been signaled by the spread in October 2000 of 700 basis points between junk bonds and treasuries, higher than the 680 basis points reached in October 1998 during the Long-Term Capital Management Crisis.

The onset of the U.S. recession will be unusual in form because of the unusual nature of the investment-led expansion that has driven stock prices and, in turn, economic behavior to extremes. The recession will be sharp. It will not be caused by Federal Reserve tightening, though the Fed will be blamed, but instead by a collapse of demand (investment and consumption) in turn driven by the simple failure of equity prices to rise in conjunction with economic behavior that could only be validated by higher stock prices.

Most recessions are caused by overheating. As the economy gets stronger and keeps growing, households and businesses keep spending more until demand growth outruns output growth. Then prices start to rise and the Fed keeps pushing up interest rates and restricting liquidity until the economy slows down. Sometimes it takes a recession to convince the happy spenders to slow down, as in 1990; sometimes it just takes an economic slowdown, as in 1994 to 1995.

The current expansion looked like a classical demand boom for a brief period, from late 1999 to early 2000. During that period, the Fed raised short-term interest rates by 175 basis points, about one-half of what it usually takes to slow the economy. Final sales--that is, demand--slowed from a 6.7 percent annual growth rate in the first quarter of this year to a 3.9 percent rate in the second quarter. The Fed stopped raising rates after a half-point boost in May, and now markets actually expect--or at least hope for--a rate cut by early spring 2001.

As election day approaches, there are signs of a sharp slowdown of investment and consumption growth that has little to do with the level of interest rates and a great deal to do with the level of the stock market. The extraordinary rise in the U.S. stock market has been fueled by strong growth of investment and productivity coupled with strong consumption growth that has, in turn, had to rely on a zero level of saving out of income by American households.

But now, the stock market, and especially the once-favored Internet and ITC sectors, are signaling an end to the investment boom. The NASDAQ index, which contains many of the most favored Internet and ITC stocks, is down 20 percent since January and down 40 percent from its April highs. Attendant falls in the Dow Jones and Standard & Poor’s indexes have left the broadest averages of equity prices about 10 percent below their levels at the end of 1999.

Signs of weakness in the ITC sector, including stocks like Microsoft, Intel, and Cisco Systems, are especially significant for the outlook of the U.S. and global economies. This is far more significant than is typical for a particular sector of the economy. The ITC sector has accounted for most of the extraordinary growth of investment and productivity over the past several years, not to mention its disproportionate contribution to rising household wealth.

The huge wealth increases generated by rising stock prices and the attendant, though much less spectacular, increases in real estate and bond prices, have increasingly led American households to rely on asset appreciation (rather than saving out of income) to achieve their savings goals. During 1999, wealth gains totaled $5.15 trillion and saving fell to 2.2 percent of disposable income, far below the long-run average of around 7 percent. This year the wealth gains are so far zero or negative, and saving out of income has fallen yet again. Americans in the year 2000 are spending more than their after-tax incomes.

Households are borrowing more to finance spending in excess of income because the huge rise in equity prices and wealth during the 1990s created an average annual wealth increase from 1990 through 1999 of $2.64 trillion. The year 1999 was extraordinary because nearly two years of the annual expected household wealth increase occurred in just one year. In 2000, households have so far felt comfortable spending all of their disposable income and then some because they achieved two years of wealth accumulation with the extraordinary rise in the stock market during 1999. Further, many appear reluctant to sell stocks and pay capital gains taxes, preferring instead to borrow against them in order to finance continued strong spending.

The most important questions about the outlook for the U.S. and global economies are these: Will the U.S. stock market end this year flat or down? What will that out-come imply for investment and spending behavior next year? The current consensus for a modest slowdown in spending overlooks the powerful negative effects on investment and consumption that could result from an absence of stock market gains, let alone a broad drop in stock prices.

Up until a decade ago, Americans wondered at the start of each year whether the stock market would go up or down. They saved about 7 percent of after-tax income to ensure that wealth would at least be maintained even if stock prices fell. By 2000, after nearly a decade of rising stock prices, Americans started the year wondering by how much the stock market would rise and saved nothing out of income, but relied instead on expected wealth gains to do their saving for them. American businesses experienced a similar transformation of expectations about stock prices over the decade and undertook more aggressive spending and borrowing plans in 2000 as a result.

It is this transformation of expectations that implies magnified wealth effects from stock market behavior during this year and next. The transformation also means that the American economy is vulnerable to the extraordinary volatility generated by investment-led booms of the sort prevalent in the nineteenth century and the early part of the twentieth century.

An investment boom starts when a new discovery or new technology opens up immense opportunities for wealth creation. Investment growth surges, and output capacity is enhanced by more capital and greater productivity of capital. Growth accelerates, but inflation does not, thanks to higher productivity growth. The rising stock of more productive capital increases labor productivity faster than wages rise, so that the real cost of labor falls and profits rise. The "new economy," with faster growth and stable or falling prices, excites investors to bid up stock prices of new-economy companies. Another round of investment follows, thanks to the low cost of capital implied by a voracious appetite for new-economy stocks. The first phase of a new economy appeared after 1995, when growth of productivity accelerated from 1 percent annually to nearly 3 percent.

The second phase, after a 1998 global scare that actually benefited the United States with lower raw materials costs and lower financing costs enhanced by a Fed rate cut, began in 1999. It crested when dot-com companies could raise billions of dollars merely by suggesting an idea about the use of the Internet. Who wanted to build an old economy refinery in 1999 when there were hundreds of new-economy dot-coms in which to invest? In other words, the white-hot phase of the new economy investment boom is reached when normal investments are starved for capital by a headlong rush into new-economy companies with seemingly limitless possibilities. There is too much investment in the new-economy sector and too little in the old economy. Bottlenecks, like inadequate refining and drilling capacity and inadequate supplies of fuel or electric power, begin to slow the economy just as excess capacity emerges in much of the new-economy sector.

Investment does not slow down when excess capacity appears. It stops. The capacity embodied in new capital equipment cannot be laid off. It has been bought and paid for (probably through borrowing). If too much ITC equipment, meaning an amount that will not allow its buyers to recoup its cost, is on hand, ITC orders are eliminated, not reduced. That is why investment-led booms end suddenly, with a collapse of investment spending.

If ITC investment, which has accounted for virtually all of investment and productivity growth since 1996, drops to zero, total U.S. growth will be cut by 1.5 to 2 percentage points. Productivity growth would also drop sharply, perhaps back to 1 percent. Real labor costs would rise, and a combination of rising labor costs and reduced pricing power (weakened by excess capacity) would depress profits. Stock prices would fall rapidly--especially in the face of dashed hopes of earnings growth rates of 30 percent per year or higher.

These stylized facts comport well with the behavior of dot-com stocks in April and May of this year and with the behavior of many ITC stocks in September and October. The main implication of these events for households has been no wealth creation during 2000. If the absence of wealth gains in contrast with extraordinary expected wealth gains causes a sharp drop (as yet unseen) in U.S. consumption, the second and decisive feature of an end to the U.S. investment-led boom will fall into place, and we shall experience a sharp recession.

How plausible is the heretical yet immensely dangerous notion of a sharp drop in U.S. consumption? If the stock market merely stays at current levels, it is quite plausible. If it falls another 15 or 20 percent, it is a virtual certainty. If stocks go back up to their April highs or beyond, the boom will end later and more painfully, after another surge in consumption.

During the 1990s, capital gains came to augment saving out of income as the way in which American households accumulate wealth. On average, the sum of saving out of income plus expected capital gains (calculated as a smooth version of average annual capital gains during this expansion) has constituted about 15 percent of after-tax household income.

With after-tax disposable income at about $7 trillion in 2000, the 15 percent rule would call for $1.05 trillion in saving. The fact that measured saving out of income is zero so far this year is consistent with the hypothesis that households in 2000 have not yet lowered their long-term expectation of substantial gains in wealth from higher stock prices.

If the stock market remains weak enough to keep wealth flat or down during the year 2000, households will start the year 2001 needing about $1 trillion in new saving or long-term expected capital gains to meet their savings targets. Past behavior shows that the stock market or other assets need to increase by about $2.75 trillion ($2 trillion after taxes) to produce an after-tax, income-equivalent capital gain that would achieve the saving target of $1 trillion. That is because households convert capital gains into income equivalents and there from into lower saving at a rate of about 50 cents on the dollar. Even if stocks are weak enough during 2001 to hold wealth growth to just a half of the long-run average (about $1.2 trillion), the income-equivalent capital gain would be just $0.48 trillion, or $0.52 trillion (about 5 percent of GDP) short of the total saving target.

Households have moved gradually to achieve savings targets of 15 percent of after-tax disposable income during times of weakness in the economy. If we conservatively estimate the 2001 saving target as just 10 percent of disposable income, or $0.73 trillion, the saving shortfall even given an income-equivalent capital gain of $0.48 trillion would be $0.25 trillion, or about 2.5 percent of GDP. A reduction of consumption by $0.25 trillion would cut 2001 GDP growth by 2.5 percentage points. A growth reduction of that magnitude (arising from lower consumption) coupled with a sharp drop of investment spending that could take another 1.5 to 2 percentage points away from growth is large enough to produce a recession in 2001.

This is not a conventional analysis of the wealth effect on consumption. The conventional view is that an actual wealth loss of $2.5 trillion would reduce consumption by about 4 percent of that amount over the following year, or by $0.1 trillion (about 1 percent of GDP). In this view, if the stock market is weak enough to keep wealth flat in 2000, there will be no negative impact upon consumption in 2001.

However, this view requires the assumption, if conventional saving out of income is zero in 2000, that households would make no downward adjustment to spending with zero saving and a possibly weakening economy in 2001. That this outcome seems improbable is a byproduct of the unprecedented contribution to wealth accumulation arising over the past decade and especially over the past few years from a sharply rising stock market. The fact of an external constraint in the form of a current account deficit above 4 percent of GDP adds to the improbability of zero private saving as a means to sustain consumption in the absence of wealth gains. Since wealth accumulation, largely from higher stock prices, has fully supplanted traditional saving in 2000, the impact on future spending if there is no wealth accumulation in 2000 could be substantial.

No analysis of the entry into a recession after an unconventional investment-led expansion would be complete without examining the possible options facing the Federal Reserve. A critical question involves the degree to which the expectations of households and businesses of continued substantial increases in stock prices and wealth are contingent upon the expectation that the Federal Reserve can and will move aggressively to stem a collapse of share prices. The Fed’s objectives, to maintain price stability and orderly financial markets while avoiding systemic risk, coupled with its actions in 1998 in response to what it deemed systemic risk in the Long-Term Capital crisis, leave open the likely nature of its response to a rapid drop in share prices. The Fed’s problem is complicated by the stagflationary shock from higher energy prices and by the fact that the United States is borrowing over 4 percentage points of GDP from the rest of the world to finance an investment boom. If that investment boom ends for legitimate reasons tied to the under-performance of investments in the new economy, part of the approach to stabilizing the dollar would be to engineer a sharp drop in U.S. spending growth that, in turn, reduces American borrowing requirements with respect to the rest of the world.

If the limited past experience of the role of central banks at the end of investment-led recoveries is any guide, the best the Fed can hope to do is to avoid making a bad situation worse. That would probably involve gradually lowering short-term interest rates and providing enough liquidity to avoid unwarranted solvency problems, but not to underwrite excessive borrowing.

However it proceeds, the Fed must find a way to move households and businesses steadily away from the situation where the behavior of the stock market has a bigger impact on the economy than the economy does on the stock market. That situation is untenable because it leaves the Fed in the uncomfortable position of having to
target the stock market in order to control the economy. Many market players already believe that the stock market is so important that the Fed must and will put a floor under stock prices to avoid a recession. The only way the Fed can move back to a situation where it aims for bedrock objectives like price stability is to allow the stock market to reflect under-lying economic realities.

Once it has given a clear signal that it is not in the business of supporting any particular level of stock prices, the Fed can begin to move to stabilize the economy and encourage a resurgence of growth based on the sound economic fundamentals that still prevail in the U.S. economy. At that time, tax cuts could be very helpful as a stimulative measure.

The problem facing the Fed is not the fact that U.S. economic fundamentals are unsound or that inflation is about to burst forth. Rather, the problem is that too many decisions are being made on the expectation that stock prices will continue to rise--an expectation in turn based on unrealistic predictions about the pace of earnings growth in the new economy.

John H. Makin is a resident scholar at AEI.