Since the 1980s, the Dow Jones Industrial Average, adjusted for inflation, has grown at an average rate of about 6.7% per year, reaching new highs of 30,000 in November 2020 and 34,000 in April 2021. But the Dow has not always followed this growth pattern. If one takes the long view – focusing on the evolution of stocks since World War II and not letting sharp short-term fluctuations obfuscate matters – a very different picture emerges.
In 1981, the Dow (inflation-adjusted) was at the same level that it stood at in 1946, suggesting that there was zero growth over that 35-year period. But that does not mean the unprecedented rise in stock-market valuations since the early 1980s is a bubble. Bubbles are whimsical, short-lived phenomena. They are not driven by fundamental changes in the economy, nor are they backed up by firms achieving results that justify their seemingly outlandish valuations.
The most valuable firms today are genuinely thriving, turning huge profits that justify their high valuations. Apple, Visa, Johnson & Johnson, Facebook, and most other major companies that everyone knows and loves (in some cases) have enjoyed unprecedented success in recent years. The question, then, is what has happened since the 1980s to account for this massive, sustained stock-market boom.
TECHNOLOGICAL SPEED KILLS
The new technologies of the digital age have brought enormous improvements to our quality of life. These gains are widely reflected in better goods and services with lower production costs. No other company currently can manage logistics at as low a cost as Amazon can.
But that’s the problem: increasingly powerful cost-saving technologies are helping incumbents keep competitors out, by enabling enormous economies of scale and creating network effects that reward size. Who wants to sell on an auction platform that has far fewer potential buyers than are available on eBay?
These trends – rapid technological change and the emergence of huge economies of scale – have created a winner-take-all contest in more and more industries. As the Netscape co-founder turned venture capitalist Marc Andreessen put it in 2011, software was “eating the world.” Those who were in a market early (the eBays and Facebooks) grabbed it all, while most new platforms couldn’t even get a foot in the door. In this world, companies initially compete for a market, but once a winner is crowned, competition in the market essentially ceases to exist.
Fast technological change is not new, of course. There were similar developments during the Second Industrial Revolution from the end of the nineteenth century until the onset of World War I. With the advent of railroads, oil, electricity, the telegraph, and telephone communication, first movers gained a dominant share in the market, often after stiff competition. Once a firm had achieved its position on top, it could keep out competitors through enormous economies of scale.
In this earlier episode, costs dropped enormously but prices did not, which helps to explain why it became known as the Gilded Age. With the expansion of railroads, the cost of traveling from the East Coast to the West Coast of the United States fell by as much as a factor of ten compared to travel in horse-drawn carriage, yet the price paid by the customer fell only marginally.
The profits that dominant Gilded Age firms generated are functionally comparable to the high stock-market valuations we see today. The names have changed – instead of Rockefellers, Morgans, and Carnegies, we have the likes of Jeff Bezos, Mark Zuckerberg, Sergey Brin, and Bill Gates – but the basic story is the same: a firm discovers and exploits new technologies to lower costs dramatically while keeping prices only slightly below where they were. The same technologies that drive material progress also stifle competition and reinforce firms’ dominant positions, ushering in a near-universal, decades-long concentration of market power.
A CONCENTRATED HIGH
My own research shows that since the 1980s, there has been a steady increase in market power, understood as a firm’s ability to set prices higher than the cost of producing what it sells. For obvious reasons, savvy investors bet on firms with significant prospects for expanding their market power. The key to Warren Buffett’s success over the past few decades is his ability to pick out these castles with “wide and long-lasting moats.”
When the pharmaceutical company Mylan jacks up the price of an EpiPen by almost 550%, its stock price rises because investors believe that this exercise of market power will increase its profits. As you would expect, the firms with the most market power are those with the highest stock valuations. With fewer market participants, each firm commands a larger market share and can leverage its position to extract ever-higher profits.
This practice shows up clearly in the data. My colleagues and I measure a firm’s stock-market performance as the ratio of its stock-market valuation to its sales. We have found that across all listed firms, the average of this ratio has risen by a factor of three since 1980, from less than 0.5 to over 1.5. This enormous increase reflects investors’ expectations of an increase in future dividends (because a firm’s valuation is an indicator of its future profitability).
Never has the problem of market concentration been more manifest than during the COVID-19 crisis. Although US unemployment soared above 14%, and GDP dropped by nearly 10% when the pandemic arrived, the stock market rebounded quickly. Three months after the start of lockdowns, listed firms’ share prices had fallen 15%, on average, but their profits had recovered, because they had managed to reduce costs commensurately.
Moreover, because these companies don’t face competition, their profits are expected to rise even further despite a reduction in sales. For the dominant firms on the stock market, competition may continue to weaken as smaller firms are forced to declare bankruptcy. And far from being limited to the Silicon Valley giants, the effects of market concentration show up across all industries, from tech to textiles. Though most of these firms are not selling tech, they can use new technologies to innovate and reduce their costs. As a result, consumers are now paying too much for too many things, from beer to pacemakers.
A SICK ECONOMY
Viewed in context, the stock-market high of the last four decades is not a sign of economic health. In a competitive economy, markets where firms are making huge profits will attract new entrants who see an opportunity to capture a share of those gains. Even if a leading firm improves its products or technologies to stay ahead, its competitors will follow suit and innovate, too.
It is this competition that keeps market power in check and prices low. But with today’s enormous economies of scale and network effects, first movers can and do use their disproportionate market power to keep competition at bay. And because market power is endemic, it has profound implications across the entire economy. While stock prices have grown robustly, the economy has been slowly getting sicker, as the higher prices that market power creates ripple through all economic sectors.
It is no coincidence that business dynamism has been stalling, even in Silicon Valley. This may come as a surprise, but the number of start-ups created each year, on average, has been falling steadily, to half that of the 1990s. By allowing just a few giant dominant firms to crush most innovators and start-ups, market power stifles innovation.
While we are blinded by the apparent stellar performance of several hundred dominant firms – or fewer, as there are only 30 firms in the Dow Jones Index, their share prices all propped up by market power – we lose sight of the six million firms in the US. Today, most small and medium-size firms generate lower profits and face harsher business conditions than ever.
It also lowers wages. With higher prices, fewer quantities are sold and produced, which lowers demand for labor and hence wages. The typical worker is hit twice: her wages fall as a result of lower labor demand, and what she consumes is sold at monopolistic prices, further reducing her purchasing power. As if this was not bad enough, most workers are hit a third time because they hold no stocks and therefore forgo the financial gains of market power.
Moreover, households that don’t hold stocks are numerous and growing in quantity, which increasingly skews the distribution of both income and wealth. At the same time, many of those who have little wealth and are bearing the brunt of a sick economy’s symptoms are in the dark about what is really going on. If current trends continue, many of our children will be among the losers. Young people today already have lower-paying jobs and substantially less wealth than their parents’ generation, which is why they marry and buy homes at later ages than their parents did.
Meanwhile, others are enjoying the stock-market high and barely suffering. The fact that you are reading this means there is a good chance that you are a beneficiary of market power. You may be feeling the costs only in the form of higher insurance premiums (perhaps for an overpriced EpiPen for your child). And yet, even if you are a net winner, your capital gains do not outweigh all the losses of those around you and to society. The losses of a sick economy vastly outweigh the gains from high stock prices.
And the massive policy interventions to resuscitate the economy after shocks like the 2008 financial crisis and the pandemic will make a sick economy sicker, because they tend to favor disproportionately the shareholders of large companies. Why should taxpayers bail out large companies and thereby guarantee a huge payout to shareholders who decided to take a risk? They should not, of course. With bailouts, there is only ever an upside risk, financed by taxes mainly on workers.
WE NEED AN INTERVENTION
The continuing rise of stock-market indices suggests that there is no end in sight to the concentration of market power. But we, as a society, can do something about it. If we are serious about achieving a meaningful recovery for an economy that is suffering from a stagnating labor market and weak new-business creation, we will need to increase competition.
That doesn’t necessarily mean we should break up large firms. Some mergers and acquisitions – such as Facebook’s purchases of Instagram and WhatsApp – should not have happened and should still be undone. But in the case of Amazon, for example, it would be just as unproductive to split up the company as it would have been to dig up nineteenth-century railway lines. We should embrace the economies of scale and the large network effects that today’s innovations engender. But we need regulation that fosters competition on the efficient networks that new technologies have created.
While every market is different, and every technology has its own needs, there are plenty of simple regulatory interventions that could boost competition. One of these concerns “interoperability.” For example, prices for mobile services are 2-3 times higher in the US than in Europe, even though the markets are comparable in size and the technology is identical. That huge difference reflects a small but crucial difference in antitrust regulation between the two jurisdictions.
The difference is that, unlike the US, Europe requires interoperability: the owners of a cell-tower network must allow competitors to use that network at a rate of compensation set by the regulator. If a Peruvian operator wants to offer mobile services in Germany and France, it doesn’t have to build its own (largely redundant) infrastructure to do so.
The results of this policy have been astounding. Europe has more than 100 mobile competitors, compared to just three major ones in the US. Such interventions lead to more competition and lower prices, and if they are implemented across all sectors, they can revitalize the entire economy, increasing innovation and output, encouraging start-ups, and fostering wage growth.
The stakes are high. In my research with economists Jan De Loecker and Simon Mongey, we estimate that the annual cost of dominant firms not facing competition in the US amounts to 9% of GDP. That is far too high a price to pay to get high on stocks. As output growth slows, even Buffett will eventually feel it in his portfolio.
More important, the longer we keep the anti-competitive stock-market boom going, the greater the economic polarization that will follow – that is, until we reach a tipping point. Eventually, the vast majority of people who are drawing the short end of the economic stick will no longer be willing to play by the rules, especially when they see those rules being bent in favor of profits and rents.
The underlying economic tension has already begun to translate into political conflict, and it is only a matter of time before it spirals toward severe social strife. Even if the stock-market high is not a bubble – even if the fundamentals based on profits are real – euphoria is never permanent. And when the come-down happens, the consequences will be far worse and longer lasting than a recession. The last century’s decades-long boom, also driven by market power, culminated in two world wars and the Great Depression.
It is important to remember that “pro-business” is not “pro-market,” especially when there are enormous economies of scale involved. A lack of regulation has tilted the balance in favor of a small number of large businesses and those with wealth in the form of stocks, and away from what is needed to sustain a dynamic, competitive market economy.
Looking ahead, we must raise output with lower prices, higher wages, and – yes – lower returns on stocks of those few hundred dominant firms. We can do so by reining in market power and restoring competition throughout the economy for all six million firms. Curing the sickness would mean returning to the competitive markets as we knew them prior to the 1980s. A Dow below 10,000, rather than above 34,000, would be a sign of good economic health.
But in the current political environment, with the winners high on stocks and the losers distracted by ginned-up culture wars and sedated by endless streaming entertainment, your pension fund is in no imminent danger – for now.
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