Assessing various scenarios for what lies ahead for the economy and the markets once we come out of this bog, I’m struck that the relative performance of the major market indexes over the past several years tracked a remarkable rise in market-wide risk preference, followed in the past year by a crushing compression of the market’s capacity to absorb risk. 

The earlier rise in the market’s risk propensity was part and parcel of an extraordinary period of capital formation and technological innovation which gave rise to what is now seen as a “productivity revolution.”  That capital-rich environment, of course, also spawned GDP growth rates of 4-5% with the fastest growth of real wages in a generation, all accompanied by essentially zero inflation. Alan Greenspan, however, took at his mission to put the brakes on what he erroneously considered an “overheating” economy, and in so doing threw a huge wrench into the gears of this wealth-creation machine.

The damage done, it seems to me, will not be so easily repaired. Even after the economy comes out of its current downturn, we’re likely to see significantly more sluggish economic performance than had become the norm of 1997-2000.  After the wipe-out of the past year, it’s going to take time for the market’s risk preference to be restored to anything approaching it’s earlier levels. That means less innovation, slower growth and at least a hiatus in the elevated productivity gains recorded recently. It also means the higher-risk sectors of the equity market are unlikely to see a robust recovery any time soon.