Last week, James Hamilton posted the following chart of cyclically adjusted P/E over the last century. The blue line is the ratio of real value (in 2009 dollars) of S&P composite index to the arithmetic average value of real earnings over the previous decade and the red line is the historical average:
One way to interpret this is that stocks are overvalued and we’re primed for an aftershock crash. Another way of looking at it is that markets are anticipating some rapid earnings growth as the economy recovers. Both hypotheses are consistent with the basic idea that someone who buys stock today is likely to see a below-average return. But they have different implications for the overall economic outlook. I’m a sunny guy, so I suppose I lean toward the latter. But what’s important isn’t so much whether one wants to be an optimist or a pessimist, but where one sees the balance of policy risks. Like Paul Krugman I worry that political actors will find themselves motivated to take the earliest signs of growth as a reason to cancel growth-boosting policies. In particular, the whole debate about a jobs bill can easily be rendered moot if the Fed decides it’s time to tighten.
This is all a bit nuts. As long as the level of economic activity remains so clearly depressed—people unemployed, office space unrented, factories not working—then policy needs to remain oriented on spurring the renewed utilization of the people and facilities currently sitting idle. You sometimes face tradeoffs between short-term and long-term issues, but there’s nothing to be gained over the long-term from having people, space, and equipment sit around going unused for lack of appropriate public policy. The time for demand-boosting policy will end when there’s a decent argument to make that we don’t have an unusual amount of idleness.