Stock markets reflect politics

Robert J. Shiller, Project Syndicate

Many economic and financial analysts complain that emerging countries' stock markets are often heavily manipulated by their governments and are more political than economic. The unstated assumption seems to be that, in contrast, some pristine force of economic nature drives stock markets in advanced countries, and that forecasting their performance is thus like forecasting the growth of trees.

This description of stock markets in emerging countries is not wrong, just biased, because the same description applies to stock markets in advanced countries. Indeed, the best analysts know that forecasting the performance of any country's stock market substantially means forecasting how well the government wants stock market investors to fare in the current political environment.

Consider the United States stock market, by far the world's largest. The general perception is that the government leaves companies alone and that the returns from investing in the U.S. stock market reflect the fundamental forces of a strong capitalist economy. This is one reason why the U.S. is a magnet for portfolio investors from around the world.

But the returns that make U.S. stock markets so attractive reflect a delicate political balance. In particular, tax rates that affect stocks have varied through time as political pressures change. During World War II, for example, political support for great fortunes diminished and the government sharply increased taxes on capital gains, dividends, and high incomes in general. When World War II produced a strong recovery from the Great Depression of the 1930s, President Roosevelt and Congress slapped on an excess-profits tax to ensure that shareholders would not benefit too much.

By contrast, in 1980, when there was no war but the stock market was low, U.S. voters elected Ronald Reagan, a man many thought too right wing to be president. He asked for -- and got -- cuts in capital gains, dividend, and income taxes.

Political interference in the stock market is not merely about taxes on capital gains, dividends, and income. Property taxes, excise taxes, import duties, and sales taxes -- all of which are paid, directly or indirectly, by corporations -- can have a magnified impact on corporate profits, and hence on the stock market. It is no coincidence that wherever stock markets thrive, governments take care that these taxes stop well short of destroying after-tax corporate profits.

Indeed, the politics of stock markets does not stop with taxes. On the contrary, almost every activity of government has an impact on corporate profits, and in turn, on the stock market.

After the 1929 stock market crash the U.S. government suspended much anti-trust activity, allowing companies to acquire monopoly power that would boost their value. This policy delayed the recovery from high unemployment, but even that was not enough to rein in the political forces arrayed in favor of supporting the stock market.

Similarly, one of the most important things that President Reagan did was to destroy much of the remaining power of America's labor unions, which compete for their share of the corporate pie. Reagan's defeat of the Air Traffic Controllers' strike in 1981 was a watershed event for the U.S. labor movement -- and for the stock market, which started its dramatic bull market in 1982.

The U.S. government has been particularly aggressive in supporting the stock market since the peak of the equities price bubble in 2000, most notably cutting interest rates repeatedly. Of course, this was publicly justified in terms of stimulating the economy, not supporting the stock market. But it is a telling sign of the U.S. stock market's significance that one of the most important factors perceived to be weighing on the economy was declining equity prices.

Indeed, the authorities' response was not limited to monetary stimulus. The U.S. National Income and Product Accounts show that the effective rate of corporate profits tax (the percentage of profits actually paid to the government in taxes) crested at 33.7 percent in the first quarter of 2000 -- the peak of the stock market and the economy in general -- and fell to 20.2 percent in the fourth quarter of 2003, when the market was down. Much of that decline reflects explicit tax relief measures voted by Congress, as well as the perception among corporations that in the current economic and political environment they can be more aggressive in tax avoidance.

Moreover, after the stock market crash, the maximum tax on dividends paid on stocks was slashed from 35 percent to 15 percent, giving a substantial new advantage to long-term investors and boosting the compounding effect of reinvesting after-tax dividends. Again, this tax cut was justified in terms of stimulating the economy, which can, of course, be said of practically any measure aimed at supporting the stock market. But it is the balance of political forces that determines whether such a justification will be credible.

One might say that the same variables, including hostility to high taxes and a weak labor movement, have operated in the U.S. for the past 200 years -- and can thus be expected to continue operating in the future, producing high stock market returns and attracting huge inflows of foreign investment. Those who believe that investments in the U.S. stock market will maintain the same strong growth trend for decades may well be right. But one should be clear about what one is forecasting. Essentially, one is forecasting not just economics, but politics -- and even the cultural values -- that shape economic policies and performance.

The writer is Professor of Economics at Yale University, and is the author of Irrational Exuberance and The New Financial Order: Risk in the 21st Century.