Overvalued stock markets are becoming a lever of US government policy

One of the core assumptions held by investors is that over time governments will undertake policies aimed at smoothing economic and financial cycles. Such policy actions are generally held to be in the best interests of both governments and investors as they maximise the potential of achieving sustainable long term growth. Yet this may not always be the case as rising levels of indebtedness may encourage governments to adopt destabilising policies in the hope of encouraging the innovative technology necessary to boost longer term growth. Nowhere is this risk greater than in the US which has potentially major implications for stock markets and investors.

Government Policy as an Economic Stabiliser

There are many reasons why in the shorter term economies can operate at levels which are viewed as being ‘out of balance’. In turn policymakers have a number of levers available to try to correct the drivers of such imbalances. Government actions in these circumstances are called demand management or stabilisation policies. Government stabilisation policies are simply economic measures utilised by policy makers to smooth out business cycle fluctuations and maintain steady growth, low inflation, and full employment. The policy levers available to smooth the business cycle include taxing and spending actions and changes to interest rates and the money supply. In the short run such policies are important as :

• it is easier to alter the various components of overall demand for a short time than it is to make the longer term structure changes required to address productivity and
  
• less volatile growth paths are viewed as being more sustainable and socially equitable.
  

Stabilisation policies are accordingly a key means by which governments can lay the foundation for more sustainable longer term economic growth by helping lower inflation, smooth out consumption and investment, and reduce government deficits.

The focus on stabilisation policies was a key component of what was to become known as the ‘Keynesian Revolution’ which drove government policy setting from the post World War II era until the 1980s. What distinguished the Keynesian revolution from previous approaches to economic management was the belief in activist policies to reduce the amplitude of the business cycle. Specifically governments aimed to use policy levers to solve problems in the short run rather than wait for market forces to fix things over the long run. Famously when addressing the question of economies self correcting in the long term Keynes wrote “In the long run, we are all dead.”

The failure of governments to address the issues associated with stagflation in the 1970’s saw a swing away from direct public investment and government intervention/involvement and towards the belief that private markets allocated capital more efficiently. The result was the rise of the Neoliberals in the 1980’s as initially championed by the Ronald Reagan and Margaret Thatcher eras. Neoliberals focused on advocating free market capitalism with policies directed at deregulation, cutting taxes, and maintaining low, stable inflation.

In principle the Neoliberals aimed at having the government become less involved in managing the economic cycle. Though conceptually the Neoliberals belief in smaller government should have resulted in fiscal restraint, in practice the result was a dramatic loosening of fiscal policy and the running of significant deficits and accumulation of large levels of government debt. It is no coincidence given the way that Neoliberalism was implemented that the post 1980’s have been associated with a dramatic increase on government debt from around 30% of GDP over the 1970’s to over 120% in 2026 (see Figure 1).

Ironically as government debt levels increased the Neoliberal mindset may have started to become a constraint. There are three levers to manage a deficit and associated debt levels. The first two levers involve either expenditure cuts or tax increases which were difficult to implement. The ideology associated with Neoliberalism made tax increases very difficult to sell to the political and business elite. On the other hand the political reality of major expenditure cuts was difficult to sell to the general electorate. This ultimately left the third lever which was a focus on economic growth as a means of reducing deficits. The logic being that tax cuts and deregulation would boost growth sufficiently that the extra tax revenue generated would pay for the increased government expenditure and thereby stabilise the deficit. Whether in theory this was ever practical became largely irrelevant as US deficits grew beyond the scope of normal economic growth to stabilise. Yet this increased focus on growth as the key lever for reducing the debt burden may have had the unintended consequence of dramatically impacting on how government policy responds to asset prices and more specifically the stock market.

Stock Market Overvaluation and Economic Growth

One of the key drivers linking the stock market and government policy is the feedback loop between corporate investment and stock market valuations. Within an efficiently operating market it is anticipated that there will be a positive relationship between corporate investment and share market valuations. The well documented explanation for this observed positive association is the “q-theory of investment” as originally set out by Tobin in 1969. In an efficient market, stock prices reflect the market's information regarding, or assessment of, a firm's investment opportunities or its marginal rate of return on capital. It follows that in an efficient market the greater the market’s assessment of a firm’s rate of return on capital the higher its stock price. Under the “q-theory of investment” as higher stock prices accurately reflects stronger growth opportunities, so high valuation firms invest more to exploit better opportunities. If the incremental investment of a high-valuation firm is for innovative purposes the firm should achieve greater innovative output, in the form of new discoveries, techniques, or products.

The linkage set out above can be viewed as efficient as it flows from the profitability of investment opportunities to stock market valuations. What many may not be fully appreciate is that similar effects may arise when markets are inefficient and investors misvalue firms. Under what has been referred to as the ‘mis-valuation hypothesis of innovation’, firms may respond to the overvaluation by engaging more heavily in innovative activities, resulting in higher future innovative output. Further the overvaluation may encourage more risky and creative forms of innovation.

Why this occurs can be the result of several factors as outlined by Dong, Hirshleifer and Teoh [Stock Market Overvaluation, Moonshots and Corporate Innovation (2018)]. These include :

• Equity overvaluation can stimulate investment by encouraging the firm to raise more equity capital to exploit new shareholders. If firms are inclined to invest the additional funds, overvaluation encourages investment.
• A governance channel may impact behaviour as managers of an overvalued firm could feel insulated from board or takeover discipline, and therefore may be more willing to undertake risky innovative activity.
• A catering channel may arise as corporate investment is more sensitive to stock prices for equity-dependent firms than for non-equity-dependent firms. The logic is that managers of equity-dependent firms have incentives to issue equity on more attractive terms to finance investment when their stock prices are overvalued. On the flip side the same managers would rather forgo their investment opportunities when their stock prices are undervalued. Managers who prefer high current stock prices may spend heavily, even at the expense of long-term value, to cater to investor optimism about those investment opportunities that investors find appealing. The incentives may be especially strong for innovative spending, as innovative activities are exciting to investors and especially hard for the market to value.
• Managers themselves may share in the positive sentiment of investors that is the source of overvaluation. This risks creating a dangerous feedback loop as the overvaluation may cause management to increasingly believe that what they are doing or promising is reflective of true sustainable returns.
• Managers may be rationally cognisant of overvaluation, but the positive sentiment of consumers, suppliers or potential employees may improve the firm’s opportunities in factor and product markets, making innovative activity more profitable.

The risk of markets being inefficient increases if the nature of the investment is innovative or transformational. This occurs as, while the market may know that a technology will permanently affect society, the pioneering nature of the technology makes assessment of (a) ultimate level of long run industry profitability and (b) separation of gainers and losers (which firms ultimately ‘divvy up’ that profitability) highly problematic. Put another way with transformational technology the assessment of the marginal return on capital for a particular company, and the industry as a whole, has a much higher degree of uncertainty and accordingly is more prone to optimistic over estimation. The overall result is that the market may have a greater tendency to materially overestimate the total value of the opportunity set opened up by the new technology. Given the feedback loop between overvaluation and investment the inefficiency has a greater potential to create a material over investment in the innovative/transformation technology thereby lowering the longer term returns from investment; i.e. the inefficiency ‘sows the seeds’ for its own correction.

Both efficient and inefficient market theories imply that higher stock prices will be associated with higher corporate investment. This includes both the creation of tangible assets through capital expenditures, and the creation of intangible assets through research and development (R&D). Importantly one of the areas where inefficient markets diverge is that mis-valuation can affect the ‘ambitiousness’ of a firms innovative activities. When a firm is overvalued, management may have greater freedom to engage in ‘moonshot’ projects,. A ‘moonshot’ project is an exceptionally ambitious, exploratory, and radical undertaking that aims to solve a massive problem with a breakthrough solution rather than an incremental gain. Needless to say such projects are exceptionally risky involving radical solutions to problems and usually development of breakthrough technology. Overvaluation can relax financing constraints on such projects, and can allow an ambitiously innovating firm to maintain a high stock price. Overvaluation can therefore help offset the limiting effect of managerial risk aversion on the riskiest forms of innovation. It is often for this reason some of the most outlandish investment proposals from companies come towards the heights of stock market overvaluations.

Overvalued Stock Markets as a Lever of Government Policy

Where maintaining economic growth is a key objective of government policy, stock market valuations can now have a material impact on the asymmetry of government policy settings. It is fair to say that policy asymmetry has always been a feature of government policy setting even during the era dominated by Keynesian policy making. Governments are just like individuals in that they seek to avoid pain as much as possible while also seeking to prolong pleasure. The question isn’t whether there is a policy asymmetry but rather the degree of policy asymmetry. The danger is that as debt levels grow the level of policy asymmetry will increase accordingly as governments look to economic growth as the key tool to manage deficits. Both fiscal and monetary policy become highly accommodative to offset any slowdown in economic activity but increasingly are slower to act to offset above trend growth. With little prospect of repaying the massive levels of debt accumulated, US governments may have become increasingly preoccupied with maximising growth as the key policy lever by which they can manage the level of debt.

It is in this context that the overvaluation of stock markets becomes not only something to be increasingly tolerated by US governments but actually encouraged. For a government wanting to maximise growth as the only means of reducing the budget deficit, and associated debt burden, encouraging new investment which may result in transformational technology is an increasingly attractive option. Indeed, in the absence of the political will to cut expenditure or raise taxes it is the only remaining option. Effectively the government is hoping that ‘moonshots’ undertaken by the private sector will rescue them from their fiscal hole by creating a technology which will transform the economy and unleash a period of exceptional growth. Yet underpinning this is the need to maintain overvalued stock markets to encourage private sector firms to make such high risk bets. The government has effectively stepped back from being a stabilising force and has now become an increasingly destabilising force by increasingly tolerating, or even encouraging, overvalued stock markets; i.e. overvalued stock markets have become a quasi lever of government policy . It is in this context that US Treasury Secretary Scott Bessent’s claims that AI will save the day by generating massive productivity growth and thus enormous tax revenues to fill the government’s coffers should be viewed. In effect the US government becomes more akin to a gambler who already being in debt goes double or nothing as there really isn’t anything left to lose.

As successive US governments increasingly rely on economic growth as a means of managing deficits their policy responses are likely to become more asymmetric. This policy asymmetry, the desire to dampen economic slowdowns and encourage booms, is a logical progression given the pro growth focus as a means of sustaining high debt levels. For investors this adds additional risks as governments may seek to tolerate, or even encourage, stock market overvaluation as a means of boosting investment and the type of innovation necessary to support materially higher level of growth over the longer term. The result may be more pronounced stock market cycles with more sustained momentum driven rallies punctuated by shorter but more severe corrections. Whether this is positive or negative for stock market investors is open to debate but the existence of such biases warrants greater care when interpreting the messaging coming from policy makers and hence how one should invest.