Still from Ex Machina.
The US economy has had two major bubbles in the last three decades. There are signs that we are in the midst of a third.
In the late 1990s there was a tech bubble, driven to a large extent by excitement over the potential of the Internet. This drove stock prices to a peak value of 43.8 times earnings (known as the price-to-earnings ratio, or P/E), according to the calculations of Nobel Prize- winning economist Robert Shiller.
This bubble began to burst in March of 2000. The S&P lost almost 50 percent of its value at its trough two-and-a-half years later in October of 2002. The NASDAQ, which included all the major tech stocks, lost almost 80 percent of its value over this period.
The collapse of the bubble was a huge hit to the economy and the labor market. Measured by output, the recession that took place in 2001 due to the collapse was relatively mild, but measured by employment, it was huge. Job growth turned negative in March of 2001.
The economy did not get back the jobs lost for four full years. This was the longest period without job growth since the Great Depression. The weak labor market also brought the strong real wage growth of the late 1990s to an end, as the real median wage rose less than 1.5 percent from 2001 to 2007, when the next recession hit.
The Collapse of the Housing Bubble
The recovery from the collapse of the tech bubble was driven by the growth of a massive housing bubble, as inflation-adjusted house prices rose by 70 percent from 1996 to 2006, after being roughly flat for the prior century. Over the years from 2007 to 2010, most of this increase was reversed.
The consequences were enormous. Residential construction, which peaked at 6.7 percent of GDP in 2005, fell back to just 2.4 percent of GDP in 2010. This drop of 4.3 percentage points of GDP would be equivalent to losing more than $1.3 trillion in annual demand in today’s economy. The loss of trillions of dollars housing wealth also curtailed consumption.
The impact on the economy was massive, as GDP growth was almost 0 in 2008, and the economy shrank by 2.7 percent in 2009. The unemployment rate peaked at 10.0 percent in October of 2009. Job growth for 2008-10 was more than 12 million below projections. Millions of people also lost their homes.
Bursting Bubbles Are a Big Deal
This recent history is important to keep in mind as we look at the AI bubble. The bubble is arguably even larger relative to the economy than the tech bubble when it peaked in 2000. According to Shiller’s calculations, the PE in the stock market, at 39.6, is slightly lower than it was at the 2000 peak. However, after-tax profits are nearly twice as large a share of GDP than they were in 2000. That means that the value of the stock market relative to the economy is nearly twice as large as it was at the peak of the tech bubble.
The current value of all corporate stock is close to $80 trillion, more than 2.5 times GDP. If PE ratios fell back to their long-term average of just under 20, it would destroy close to $40 trillion in stock wealth, an average of almost $300,000 per household. If the PE fell back to its long-term average, and the after-tax profit share of GDP also fell back toward their level of a quarter-century ago, then the loss of wealth would be even larger.
It is impossible to know the timing for when a bubble will collapse. A quarter of a century later, it is still not possible to identify any event that caused the 1990s tech bubble to collapse. It’s also not clear what caused the housing bubble to stop growing and start deflating.
With that in mind, it is possible to track the bubble, looking at the growth in the prices of the most important stocks and changes in their PE. This is what the AI Bubble Monitor will do on a weekly basis.
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This first appeared on Dean Baker’s Beat the Press blog.
