Less than two months after the CDC declared COVID-19 a public health emergency on February 3, 2020, the stock market slump that followed abruptly ended and equities have rocketed upward ever since. The Wilshire 5000 Total Market Cap Index, the most comprehensive measure of the market value of publicly traded U.S. corporations, nearly doubled to record highs from the March 2020 lows, rising from $22.5 trillion to $43.3 trillion by late May 2021.

The economy proved no less resilient. On the heels of the shortest major recession on record, resurgent GDP (gross domestic product) rebounded to the December 2019 peak by the end of the first quarter of 2021, reaching $22.1 trillion. Economically and financially, the headlines telegraphed ‘All’s well.’

The 1948 Chicago Tribune headline, ‘Dewey Defeats Truman,’ reminds us, however, that sometimes there’s more to a story than what appears above the fold.

Going Beyond GDP

GDP, conceived in 1934 to quantify recovery from the Great Depression, is typically expressed as a spending identity: Consumption + Investment + Government Spending + Net Exports. This measure is essentially the nation’s income and expense statement. Is that headline metric, in concert with stock prices, the best contemporary gauge of the nation’s economic well-being?

Though rarely part of public discourse, the U.S. balance sheet also merits attention. It undergirds GDP. For households and businesses, the health of the balance sheet’s physical and human assets is foundational in determining income and spending potentials. Conditionally, the extent to which borrowing finances those assets can affect the entity’s stability and potential for growth.

French economist Frédéric Bastiat introduced “The Broken Window” fallacy in his 1850 essay, “That Which We See and That Which We Do Not See.” To contemporize his illustration, if a January 6, 2021, insurgent threw an object that shattered a Capitol Hill window, the money expended for labor and materials to repair the damage would, because of governmental accounting conventions, be included in GDP. The loss due to the destruction, however, would not be deducted from GDP.

The fallacy latent in GDP numbers is that money spent to replace the window would not, as the incrementally higher totals would imply, be a net benefit to society. The funds expended were effectively diverted from alternative uses that may have actually added to the nation’s wealth. We see and account for the new window, but we neither see nor account for its destruction.

A Brief History of Windows

Many windows in American have been broken over the last 20 years. The respected Brown University study of the Afghanistan and Iraq wars on terror estimated that spending from 2001 through 2020 totaled $6.4 trillion and was included in GDP. There appears to be little lasting value to show for this mind-boggling amount. Additionally, funds spent on containing terrorism were not spent on food, clothing, healthcare, or capital maintenance and improvements, like infrastructure. The stimulus from military spending was felt in one sector of the economy directly, but it was at the expense of other sectors.

It gets more troubling. An early postmortem on the cost of the coronavirus pandemic appeared in the Harvard Gazette in November 2020 by economists David Cutler and Lawrence Summers. They called the pandemic the “greatest threat to prosperity and well-being the U.S. has encountered since the Great Depression,” estimating the losses at four times those of the Great Recession.

Their approximated $16 trillion price tag includes (1) the CBO’s (Congressional Budget Office) $7.6 trillion estimate of economic output lost to the pandemic over the next decade, (2) the cost of premature deaths at $4.4 trillion, (3) the long-term disabilities of those who survived at $2.6 trillion, and (4) $1.6 trillion for mental health. Indeed, the unseen costs are enormous. Estimates for the prevalence of depression and anxiety have risen from 11% to 40% since the pandemic struck. In addition, large numbers of women, whose increasing workforce participation has been a key driver of economic growth the last 40 years, have left the workforce as childcare evaporated and service industries struggled.

Markets and the Fed

Another unseen loss may lie in waiting. The stock market is one Freudian step removed from the real economy. Because of the variability of collective human psychology and behavior—the latter in Wall Street parlance often referred to as the continuum from speculation to risk-aversion—the stock market is innately far more volatile than its underlying referent. No matter how manic or depressive its mood swings, though, it is ultimately tethered, as if by a bungee cord, to the economy itself. A measure of the extent to which the bungee cord is slack or stretched was conceived years ago by Warren Buffett. The market capitalization-to-GDP ratio is derived by dividing the Wilshire 5000 Total Market Cap Index by GDP.

The Wilshire 5000 index is $43.9 trillion, whereas GDP is $22.1 trillion—a ratio of 200%. The 80-year average of the ratio is about 75%. Taking a broad-brush look at history, bull markets have tended to peak when the ratio exceeds 100%, and bear markets have often bottomed when it drops below 50%. So how can the ratio be 200%? It’s widely believed that this time is different. The Fed has steadfastly lived up to its implicit pledge not to let the market fall. That commitment’s appeal is in its beguiling simplicity.

Although not one in 100 pundits and investors was even aware of it, on May 6 the Federal Reserve released its sixth semi-annual “Financial Stability Report.” It distinguishes between shocks and vulnerabilities, noting the latter “tend to build up over time and are the aspects of the financial system that are most expected to cause widespread problems in times of stress.” It identifies market valuation as a top financial vulnerability. In Fed-speak:

Elevated valuation pressures are signaled by asset prices that are high relative to eco­nomic fundamentals or historical norms and are often driven by an increased willingness of investors to take on risk. As such, elevated valuation pressures imply a greater possibil­ity of outsized drops in asset prices.

A rational person must wonder what it is about the warning that investors don’t see.

Debt and a Breakdown in Growth

Might there be yet another potential unseen cost about which to be concerned: the public debt? An uncomfortable amount of the aforementioned post-9/11 spending was on broken windows—wars and pandemic relief. Most of this was financed by the sale of U.S. Treasury debt instruments and, of note, with the ongoing tacit support of an unprecedentedly accommodative Fed.

Regardless of the quality of expenditures, scholarly research contends that gross national debt exceeding 60% of GDP begins to have a deleterious effect on real economic growth. The trend only worsens as the ratio rises. As of the end of 2020, the ratio had reached a new high of 129.1%, virtually doubling since the Great Recession. Although not the stuff of headlines, the longest ever expansion that ended abruptly in February 2020 produced real GDP growth of only 2.3%, compared to 3.7% from 1950 through 2007.

Paraphrasing Albert Einstein, not everything that can be seen counts, and not everything that counts can be seen. The headlines belie a potential iceberg below the surface that cannot be seen, but it very much counts—and some of it is made of broken windows.

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