Before the current turmoil began, Federal Reserve Chairman Ben Bernanke's hope was that rising asset prices would lead to a "wealth effect" that would encourage the American consumer to start spending again, and thus help the American economy finally leave the "Great Recession" behind.
His predecessor Alan Greenspan argued in February that this would work because:
"...the stock market is the really key player in the game of economic growth... The data shows that stock prices are not only a leading indicator of economic activity, they are a major cause of it. The statistics indicate that 6 percent of the change in GDP results from changes in market value of stocks and homes." (Greenspan 2013)
This is the so-called "wealth effect": an empirical relationship between change in the value of assets and the level of consumer spending which implies that an increase in wealth will cause an increase in consumption.
Greenspan's sage status is somewhat tarnished post-2007, so I don't think anyone should be surprised that his definitive statement involves a sleight of mouth. The "6 cents extra spending for every dollar increase in wealth" found in the research he alluded to was for the relationship between changes in the value of housing wealth and consumption, not stocks. In fact, the authors argued that the wealth effect from stocks was "statistically insignificant and economically small":
"Consistent and strong evidence is found for large but sluggish housing wealth effects... the MPC [marginal propensity to consume] out of a one dollar change in two-year lagged housing wealth is about 6 cents...
Furthermore, a statistically insignificant and economically small stock wealth effect is found ...
Additionally, there is evidence that the housing wealth effect is significantly larger than the stock wealth effect... these results suggest that it is necessary to take into consideration the potentially substantial difference between consumers' respective reactions to fluctuations in the housing markets and stock markets." (Carroll and Zhou 2010, p. 18. Emphasis added)
So the empirical data does not support Greenspan's notion that the stock market drives the economy (though the housing sector might). But equally the economy isn't booming sufficiently to make the reverse case that the economy drives the stock market. So what is causing the markets to boom right now?
Let's start by taking a closer look at the data than Alan did. There are a number of surprises when one does - even for me. Frankly, I did not expect to see some of the results I show here: as I used to frequently tell my students before the financial crisis began, I wouldn't dare make up the numbers I found in the actual data. That theme continues with margin debt for the USA, which I've only just located (I expected it to be in the Federal Reserve Flow of Funds, and it wasn't - instead it's recorded by the New York Stock Exchange).
The first surprise came when comparing the S&P500 to the Consumer Price Index over the last century - since what really tells you whether the stock market is "performing well" is not just whether it's rising, but whether it's rising faster than consumer prices. Figure 1 shows the S&P500 and the US CPI from the same common date-1890—until today.