Energy, the Stock Market, and the Putty-Clay Investment Model

Real energy prices jumped by 80% from 1973 to 1974. At the same time, the market value of firms plunged by 40%. Is the energy crisis responsible for the dramatic decline in the stock market? Many economists, starting with Baily (1981), have concluded that higher energy prices resulted in the effective scrappage of a substantial fraction of the capital stock. The fall in the stock market reflected the fall in the value of firms’ assets, in this view. Because capital is never scrapped in a neoclassical model of capital, I build a model based on the putty-clay specification, where different vintages of capital are imperfect substitutes. I distinguish three factors: capital, energy, and labor. I take the production technology ex ante to be Cobb-Douglas with constant returns to scale, but for capital goods already installed, production possibilities take the Leontief form: there is no substitutability of capital, energy, and labor ex post. I use the model to evaluate the impact of the energy price shock on the securities market in 1974. As a preliminary to the analysis based on the model, I calculate an upper bound on the effect of the energy price shock in a partial equilibrium puttyclay model, holding the real wage fixed. An 80% increase in real energy prices leads to a 10% decline in the market value of installed machines. Even this small effect exceeds what I find in the general equilibrium model. There, the energy price shock causes a decrease in the real wage, sufficient to offset the adverse impact of the increase in the energy cost on the value of capital. An 80% increase in the real energy prices causes the market value to decrease by only 2.2%. The theoretical analysis is supported by the observed decline in the real wage in 1974 of a magnitude comparable to that predicted by the model. Finally, I conduct a cross-industry event study that shows that the energy share of production costs cannot explain the cross-sectional patterns of the decline of stock prices from 1972 to 1974. The theoretical analysis and empirical evidence indicate that a broader set of forces was at work in causing the market downfall in 1974 than those effects of energy prices captured in the putty-clay model that appears to inform the thinking of most economists on this question.