What Do Stock Prices Tell Us about the Economy?

Stock prices (as measured by the S&P 500) in 2017 rose by over 20%, an impressive amount, and what is most impressive about it is perhaps that this rise prices came after eight previous years of steady increases.

Here are the annual year-on-year and cumulative changes in the S&P500 since 2009.

2009              21.1%              21.1%*

2010              12.0%              33.1%*

2011              -0.0%               33.1%*

2012              12.2%               45.3%*

2013              25.9%               71.2%*

2014              10.8%               82.0%*

2015              -0.7%                81.3%*

2016             9.1%                   90.4%*            (4.5%)**          (85.9%)***

2017             17.7%                 108.1%*          (22.3%)****

2018 (YTD)    2.0%                  110.1%*           (24.3%)****

* cumulative increase since the end of 2008

** increase from end of 2015 to November 8, 2016

*** cumulative increase from end of 2008 to November 8, 2016

**** cumulative increase since November 8, 2016

So, from the end of 2008 until the start of 2017, approximately coinciding with Obama’s two terms as President, the S&P 500 rose in every year except 2011 and 2015, when the index was essentially unchanged, and rose by more than 10% in five of the eight years (twice by more than 20%), with stock prices nearly doubling during the Obama Presidency.

But what does the doubling of stock prices under Obama really tell us about the well-being of the American economy, and, even more importantly, about the well-being of the American public during those years? Is there any correlation between the performance of the stock market and the well-being of actual people? Does the doubling of stock prices under Obama mean that most Americans were better off at the end of his Presidency than they were at the start of it?

My answer to these questions is a definite — though not very resounding — yes, because we know that the US economy at the end of 2008 was in the middle of the sharpest downturn since the Great Depression. Output was contracting, employment was falling, and the financial system was on the verge of collapse, with stock prices down almost 50% from where they had been at the end of August, and nearly 60% from the previous all-time high reached in 2007. In 2016, after seven years of slow but steady growth, employment and output had recovered and surpassed their previous peaks, though only by small amounts. But the recovery, although disappointingly slow, was real.

That improvement was reflected, albeit with a lag, in changes in median household and median personal income between 2008 and 2016.

2009                    -0.7%                   -0.7%

2010                    -2.6%                    -3.3%

2011                     -1.6%                    -4.9%

2012                    -0.1%                    -5.0%

2013                      3.5%                    -1.5%

2014                    -1.5%                     -3.0%

2015                     5.1%                       2.0%

2016                      3.1%                      5.1%

But it’s also striking how weak the correlation was between rapidly rising stock prices and rising median incomes in the Obama years. Given a tepid real recovery from the Little Depression, what accounts for the associated roaring recovery in stock prices? Well, for one thing, much of the improvement in the stock market was simply recovering losses in stock valuations during the downturn. Stock prices having fallen further than incomes in the Little Depression, it’s not surprising that the recovery in stocks was steeper than the recovery in incomes. It took four years for the S&P 500 to reach its pre-Depression peak, so, normalized to their pre-Depression peaks, the correlation between stock prices and median incomes is not as weak as it seems when comparing year-on-year percentage changes.

But considering the improvement in stock prices under Obama in historical context also makes the improvement in stock prices under Obama seem less remarkable than it does when viewed without taking the previous downturn into account. Stock prices simply returned (more or less) to the path that, one might have expected them to follow by extrapolating their past performance. Nevertheless, even if we take into account that, during the Little Depression, stocks prices fell more sharply than real incomes, stocks have clearly outperformed the real economy during the recovery, real output and income having failed to return to the growth path that it had been tracking before the 2008 downturn.

Why have stocks outperformed the real economy? The answer to that question is a straightforward application of the basic theory of asset valuation, according to which the value of real assets – machines, buildings, land — and financial assets — stocks and bonds — reflects the discounted expected future income streams associated with those assets. In particular, stock prices represent the discounted present value of the expected future cash flows (dividends or stock buy-backs) from firms to their shareholders. So, if the economy has “recovered” (more or less) from the 2008-09 downturn, the expected future cash flows from firms have presumably – and on average — surpassed the cash flows that had been expected before the downturn.

But the weakness in the recovery suggests that the increase in expected cash flows can’t fully account for the increase in stock prices. Why did stock prices rise by more than the likely increase in expected cash flows? The basic theory of asset valuation tells us that the remainder of the increase in stock prices can be attributed to the decline of real interest rates since the 2008 downturn to historically low levels.

Of course, to say that the increase in stock prices is attributable to the decline in real interest rates just raises a different question: what accounts for the decline in real interest rates? The answer, derived from Irving Fisher, is basically that if perceived opportunities for future investment and growth are diminished, the willingness of people to trade future for present income also tends to diminish. What the rate of interest represents in the Fisherian framework is the rate at which people are willing to trade future for present income – i.e., the premium (discount) that is placed on present (future) income.

The Fisherian view is totally at odds with the view that the real interest rate is – or can be — controlled by the monetary authority. According to the latter view, the reason that real interest rates since the 2008 downturn have been at historically low levels is that the Federal Reserve has forced interest rates down to those levels by flooding the economy with huge quantities of printed money. There is a certain sense in which that view has a small element of truth: had the Fed adopted a different set of policy goals concerning inflation and nominal GDP, real interest rates might have risen to more “normal” levels. But given the overall policy framework within which it was operating, the Fed had only minimal control over the real rate of interest.

The essential idea is that in the Fisherian view the real rate of interest is not a single price determined in a single market; it is a distillation of the entire intertemporal structure of price relationships simultaneously determined in the myriad of individual markets in which transactions for present and future delivery are continuously being agreed upon. To imagine that the Fed, or any monetary authority, could control or even modestly influence this almost incomprehensibly complicated structure of price relationships according to its wishes is simply delusional.

If the decline in real interest rates after the 2008 downturn reflected generally reduced optimism about future economic growth, then the increase in stock prices actually reflected declining optimism by most people about their future well-being compared to their pre-downturn expectations. That loss of optimism might have been, at least in part, self-fulfilling insofar as it discouraged potentially worthwhile – i.e., profitable — investments that would have been undertaken had expectations been more optimistic.

Nevertheless, the near doubling of stock prices during the Obama administration did coincide with a not insignificant improvement in the well-being of most Americans. Most Americans were substantially better off at the end of 2016, after about seven years of slow but steady economic growth, than they were at the end of 2008 when total output and employment were contracting at the fastest rate since the Great Depression. But to use the increase in stock prices as a quantitative measure of the improvement in their well-being would be misleading.

I would also mention as an aside that a favorite faux-populist talking point of Obama and Fed critics used to be that rising stock prices during the Obama years revealed the bias of the elitist Fed Governors appointed by Obama in favor of the wealthy owners of corporate stock, and their callous disregard of the small savers who leave their retirement funds in bank savings accounts earning minimal interest and of workers whose wage increases barely kept up with inflation. But this refrain of critics – and I am thinking especially of the Wall Street Journal editorial page – who excoriated the Obama administration and the Fed for trying to raise stock prices by keeping interest rates at abnormally low levels now unblushingly celebrate record-high stock prices as proof that tax cuts mostly benefiting corporations and their stockholders signal the start of a new golden age of accelerating growth.

So the next question to consider is what can we infer about the well-being of Americans and the American economy from the increase in stock prices since November 8, 2016? For purposes of this mental exercise, let me stipulate that the rise in stock prices since the moment when it became clear who had been elected President by the voters on November 8, 2016 was attributable to the policies that the new administration was expected to adopt.

Because interest rates have risen along with stock prices since November 8, 2016, increased stock prices must reflect investors’ growing optimism about the future cash flows to be distributed by corporations to shareholders. So, our question can be restated as follows: which policies — actual or expected — of the new administration could account for the growing optimism of investors since the election? Here are five policy categories to consider: (1) regulation, (2) taxes, (3) international trade, (4) foreign affairs, (5) macroeconomic and monetary policies.

The negative reaction of stock prices to the announcement last week that tariffs will be imposed on steel and aluminum imports suggests that hopes for protectionist trade policies were not the main cause of rising investor optimism since November 2016. And presumably investor hopes for rising corporate cash flows to shareholders were not buoyed up by increasing tensions on the Korean peninsula and various belligerent statements by Administration officials about possible military responses to North Korean provocations.

Macroeconomic and monetary policies being primarily the responsibility of the Federal Reserve, the most important macroeconomic decision made by the new Administration to date was appointing Jay Powell to succeed Janet Yellen as Fed Chair. But this appointment was seen as a decision to keep Fed monetary policy more or less unchanged from what it was under Yellen, so one could hardly ascribe increased investor optimism to a decision not to change the macroeconomic and monetary policies that had been in place for at least the previous four years.

That leaves us with anticipated or actual changes in regulatory and tax policies as reasons for increased optimism about future cash flows from corporations to their shareholders. The two relevant questions to ask about anticipated or actual changes in regulatory and tax policies are: (1) could such changes have raised investor optimism, thereby raising stock prices, and (2), if so, would rising stock prices reflect enhanced well-being on the part of the American economy and the American people?

Briefly, the main idea for regulatory reform that the Administration wants to pursue is to require that whenever an agency adopts a new regulation, it should simultaneously eliminate two old ones. Supposedly such a requirement – sometimes called a regulatory budget – is to limit the total amount of regulation that the government can impose on the economy, the theory being that new regulations would not be adopted unless they were likely to be really effective.

But agencies are already required to show that regulations pass some cost-benefit test before imposing new regulations. So it’s not clear that the economy would be better off if new regulations, which can now be adopted only if they are expected to generate benefits exceeding the costs associated with their adoption, cannot be adopted unless two other regulations are eliminated. Presumably, underlying the new regulatory approach is a theory of bureaucratic behavior positing that the benefits of new regulations are systematically overestimated and their costs systematically underestimated by bureaucrats.

I’m not going to argue the merits of the underlying theory, but obviously it is possible that the new regulatory approach would result in increased profits for businesses that will have fewer regulatory burdens imposed upon them, thereby increasing the value of ownership shares in those firms. So, it’s possible that the new regulatory approach adopted by the Administration is causing stock prices to rise, presumably by more than they would have risen under the old simple cost-benefit regulatory approach that was followed by the Obama Administration.

But even if the new regulatory approach has caused stock prices to rise, it’s not clear that increasing stock valuations represent a net increase in the well-being of the American economy and the American people. If regulations that are costly to the economy in general are eliminated, the benefits of fewer regulations would accrue not just to the businesses whose profits rise as a result; eliminating inefficient regulations would also benefit the rest of the economy by freeing up resources to produce goods and services whose value to consumers would the benefits foregone when regulations were eliminated. But it’s also possible, that regulations are providing benefits greater than the costs of implementing and enforcing them.

If eliminating regulations leads to increased pollution or sickness or consumer fraud, and the value of those foregone benefits exceeds the costs of those regulations, it will not be corporations and their shareholders that suffer; it will be the general public that will bear the burden of their elimination. While corporations increase the cash flows paid to shareholders, members of the public will suffer more-than-offsetting reductions in well-being by being exposed to increased pollution, suffering increased illness and injury, or suffering added fraud and other consumer harms.

Since 1970, when the federal government took serious measures to limit air and water pollution, air and water quality have improved greatly in most of the US. Those improvements, for the most part, have probably not been reflected in stock prices, because environmental improvements, mostly affecting common-property resources, can’t be easily capitalized, though, some of those improvements have likely been reflected in increasing land values in cities and neighborhoods where air and water quality have improved. Foregoing pollution-reducing regulations might actually have led to increased stock prices for many corporations burdened by those regulations, but the US as a whole, and its inhabitants, would not have been better off without those regulations than they are with them.

So, rising stock prices are not necessarily a good indicator of whether the new regulatory approach of the Administration is benefiting or harming the American economy and the American public. Market valuations convey a lot of important information, but there is also a lot of important information that is not conveyed in stock prices.

As for taxes, it is straightforward that reducing corporate-tax liability increases funds available to be paid directly to shareholders as dividends and share buy-backs, or indirectly through investments expected to increase cash flows to shareholders in the more distant future. Does an increase in stock prices caused by a reduction in corporate-tax liability imply any enhancement in the well-being of the American economy and the American people

The answer, as a first approximation, is no. A reduction in corporate tax liability implies a reduction in the tax liability of shareholders, and that reduction is immediately capitalized into the value of shares. Increased stock prices simply reflect the expected reduction in shareholder tax liability.

Of course, reducing the tax burden on shareholders may improve economic performance, causing an increase in corporate cash flows to shareholders exceeding the reduction in shareholder tax liabilities. But it is unlikely that the difference between the increase in cash flows to shareholders and the reduction in shareholder tax liabilities would be more than a few percent of the total reduction in corporate tax liability, so that any increase in economic performance resulting from a reduction in corporate tax liability would account for only a small fraction of the increase in stock prices.

The good thing about the corporate-income tax is that it is so easy to collect, and that it is so hard to tell who really bears the tax burden: shareholders, workers or consumers. That’s why governments like taxing corporations. But the really bad thing about the corporate-income tax is that it is so hard to tell who really bears the burden of the corporate tax, shareholders, workers or consumers.

Because it is so hard to tell who bears the burden of the tax, people just think that “corporations” pay the tax, but “corporations” aren’t people, and they don’t really pay taxes, they are just the conduit for a lot of unidentified people to pay unknown amounts of tax. As Adam Winkler has just explained in this article and in an important new book, It is a travesty that the Supreme Court was hoodwinked in the latter part of the nineteenth century into accepting the notion that corporations are Constitutional persons with essentially the same rights as actual persons – indeed, with far greater rights than human beings belonging to disfavored racial or ethnic categories.

As I wrote years ago in one of my early posts on this blog, there are some very good arguments for abolishing the corporate income tax altogether, as Hyman Minsky argued. Forcing corporations to distribute their profits to shareholders would diminish the incentives for corporate empire building, thereby making venture capital more available to start-ups and small businesses. Such a reform might turn out to be an important democratizing and decentralizing change in the way that modern capitalism operates. But even if that were so, it would not mean that the effects of a reduction in the corporate tax rate could be properly measured by looking that resulting change in corporate stock prices.

Before closing this excessively long post, I will just remark that although I have been using the basic theory of asset pricing that underlies the efficient market hypothesis (EMH), adopting that theory of asset pricing does not imply that I accept the EMH. What separates me from the EMH is the assumption that there is a single unique equilibrium toward which the economy is tending at any moment in time, and that the expectations of market participants are unbiased and efficient estimates of the equilibrium price vector toward which the price system is moving. I reject all of those assumptions about the existence and uniqueness of an equilibrium price vector. If there is no equilibrium price vector toward which the economy is tending, the idea that expectations are governed by some objective equilibrium which is already there to be discovered is erroneous; expectations create their own reality and equilibrium is itself determined by expectations. When the existence of equilibrium depends on expectations, it becomes impossible to assign any meaning to the term “efficient market.”

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15 Responses to “What Do Stock Prices Tell Us about the Economy?”


  1. 1 David Jones March 7, 2018 at 3:24 am

    Policies or other factors that reduce the bargaining power of workers can also be good for stocks but not for most Americans. Labor is a large part of the costs for businesses, so all else being equal, lower wages means higher profits.

    A rising corporate share of national income would suggest this has been happening. The decline in median household and personal income while stock prices rise is another indication.

    All else might not be equal, as lower median income could mean less money available to buy from corporations, lowering revenue and therefore profit. It depends on the actual numbers.

    A check on any proposed explanation is to compare US stock prices to global stock prices and US policy to global policy. For example, if stock prices are rising in all countries but US policy the differences in US policy might not be the explanation.

  2. 2 Thomas Aubrey March 7, 2018 at 6:21 am

    David

    A couple of points.

    I was wondering why you chose to assess the relationship between rising stock prices and the well-being of the American economy? The long run econometric analyses that exist between GDP growth and equity returns show little correlation between the two. (Dimson, Marsh, Staunton 2002)

    You suggest that the weakness in the recovery can’t fully account for the increase in stock prices. Again you appear to have assumed that growth and equity returns are correlated.

    Stock prices have been rising because profits have been rising. Using the Wicksellian Differential, it is possible to assess the difference between the return on capital and cost of capital which has a much closer relationship to equity returns. Although the return on capital across listed firms has largely been increasing and since 2010, the cost of capital has been falling for much of the period impacted by QE.

    The BBB cost of funding fell from around 7% in 2009 to below 4% where it has been ever since. This enabled corporations to refinance their debt at a lower rate, driving up profits.

    Finally I remain sceptical that rising stock markets can be attributed to the policies that the new administration was expected to adopt. Rising profits has been a more direct driver of rising stock prices. See here. http://lipperalpha.financial.thomsonreuters.com/2017/10/investors-should-listen-to-tolstoy-not-trump/

    However, I agree with your conclusion that rising stock prices are not necessarily a good indicator of whether the new regulatory approach of the Administration is benefiting or harming the American economy and the American public. Rising stock prices are, in general, associated with rising profits.

  3. 3 Effem March 7, 2018 at 8:12 am

    The argument that a decline in real interest rates impacts valuation is somewhat at odds with itself. Yes, all else being equal, that would be true. But the argument for low real rates is low prospects for investment growth. That leaves you with an offset: a higher valuation on a stream of cash flows with a now-reduced growth rate. Should be (roughly) a wash.

  4. 4 David Glasner March 7, 2018 at 7:00 pm

    David, I agree that a shift in the distribution of income away from labor and toward capital could be part of the story, here. That shift seems to have started back in teh 1980s already. My focus in this post was just on period since the last cyclical downturn, so I was not addressing the distributional issue. But I agree that it is relevant to a broader discussion. I wrote a post back in December “Has the S&P 500 Risen by 25% since November 8, 2016 Thanks to Economic Nationalist America First Policies?” in which I pointed out that stock prices in other parts of the world have been rising faster than stock prices in the US.

    Thomas, I think that the basic theory of asset pricing suggests that there should be some correlation between economic performance and stock prices, just as I think economic performance and profits should be correlated, but not necessarily tightly. So, I don’t see why the empirical evidence you provide is necessarily inconsistent with the theoretical account that I was offering.

    Effem, You are right that if all that was happening was that people were becoming increasingly pessimistic about future income flows, the decline in interest rates would just offset the expected decline in future cash flows. My point was that expected future cash flows are still increasing but by less than they had previously been expected to increase. The change in expectations has caused the rate of increase in cash flows to fall, but expected cash flows are still expected to rise, but the decline in the expected rate of increase is causing real interest rates to fall. So asset values are have increased.

  5. 5 kaleberg March 7, 2018 at 9:38 pm

    As an investor, I noticed that the stock market more or less divorced the economy of goods and services in the late 1980s. By the 1990 recession, it was rather obvious that the reason to by stocks was that there was nothing to invest in. If incomes had been growing, as they had before the 1980s, there would have been all sorts of investment opportunities.

    Look at where most of the recent tax cut money is going to be spent. Corporations are going to either buy their own shares, that is, disinvest, or they are going to give the money to the shareholders who will look at the investment market and low interest rates and then use the money to bid up stock prices. There are fewer and fewer corporations publicly traded and those that are have fewer and fewer shares available. It’s basically inflation for rentiers.

    Think about it. What is the value of a corporation? It’s determined by its future cash flow. Where does that money come from? It comes from consumers and the government. Only when demand from consumers and the government rises will companies buy investment goods. Most consumers have less money than they used to and governments have been slammed by various flavors of tax cutting. Future cash flow is limited. What is an investor to do?

    I know what I and so many others did, I bought shares of corporations. I was richly rewarded. I can imagine someone losing money by this strategy over the past three or so decades, but index funds have outperformed just about everyone who thought rationally about individual corporations.

  6. 6 Benjamin Cole March 8, 2018 at 5:51 am

    “I would also mention as an aside that a favorite faux-populist talking point of Obama and Fed critics used to be that rising stock prices during the Obama years revealed the bias of the elitist Fed Governors appointed by Obama in favor of the wealthy owners of corporate stock, and their callous disregard of the small savers who leave their retirement funds in bank savings accounts earning minimal interest and of workers whose wage increases barely kept up with inflation. But this refrain of critics – and I am thinking especially of the Wall Street Journal editorial page – who excoriated the Obama administration and the Fed for trying to raise stock prices by keeping interest rates at abnormally low levels now unblushingly celebrate record-high stock prices as proof that tax cuts mostly benefiting corporations and their stockholders signal the start of a new golden age of accelerating growth.”–David Glasner.

    Gee, and I thought the WSJ op-ed pages were completely sincere about fighting for those ordinary workers who were saving nickels and dimes. And that gold prices tracked oil prices that tracked a completely feckless Fed.

    OT, but someday let’s explore if a widening gap between GNI and GDP, due to increasing foreign ownership of domestic assets, could ever be a thing among macroeconomists.

  7. 7 Effem March 8, 2018 at 6:18 am

    “My point was that expected future cash flows are still increasing but by less than they had previously been expected to increase.”

    You can pull up index dividend futures to see that this is not the case. They are priced out until the mid-2020’s and have been rising steadily.

  8. 8 B Cole March 8, 2018 at 4:51 pm

    A thought: there is a school of thought among market monetarists that there is no inflation in Japan as the market expects the Bank of Japan to sell back its hoard of bonds someday.

    Interesting that you say there is no such thing as market expectations.

  9. 9 publicgood March 9, 2018 at 12:49 pm

    Great article interesting topic.
    I think there is a mistake 2015 -5.1% but the cumulative increases 5%.

  10. 10 TravisV March 12, 2018 at 11:07 am

    TravisV from themoneyillusion comments section here.

    It seems to me that the huge economic recovery of populous countries around the world has played a major role in the increase in U.S. stock prices since November 2016……..

  11. 11 kaleberg March 12, 2018 at 9:24 pm

    Rising stock prices are just inflation. When the economy was rejiggered so that wages stopped rising, the rich got a lot richer. Wage earners didn’t have enough money to drive serious inflation. Who did? The wealthy did. They had lots of money to drive all kinds of inflation. What do wealthy people buy? They buy prestige real estate, objects of symbolic importance, government insured cash flows and shares of corporations. That’s the demand side. Almost all of the increased productivity of American labor went to the rich and got turned into demand for things like stocks.

    Now consider the supply side, particularly the supply of corporate shares. Look at how many companies have gone private thanks to private equity. Look at the shrinking number of public corporations overall thanks to mergers and acquisitions. Look at the shrinking supply of corporate shares on the public stock exchanges thanks to buybacks. There have been $6.9T of stock buybacks since 2004. Increase demand. Cut supply. Guess which way the price goes?

    P.S. I grew up in an era when stock prices had something to do with earnings, profits and economic growth, but that era is long gone. Hell, I used to hang out my dad at those little brokerages with ticker tape machines and those clicker board price indicators. Don’t be mystical. Stock prices are like gold prices. It’s supply and demand.

  12. 12 David Glasner March 14, 2018 at 9:19 am

    kaleberg, I agree that investing in stocks has paid off handsomely over the past 35 years, after a 10-12 year spell of poor performance in the 1970s. My basic point is that high returns on stocks bear some relation to good performance in the larger economy, but the relationship is not tight. A shift in government policy in favor of corporations, allowing them to emit pollutants into the environment without restraint, or reducing their tax liabilities can imply substantial gains in stock prices that may be detrimental to the well-being of the rest of society. But controlling for those kinds of effects on stock prices, an improvement in economic performance should wind up being reflected in higher stock prices.

    Benjamin, And you probably believed in Santa Claus, too. Interesting thought about GNI and GDP. I won’t pursue it, but I hope someone else will.

    Effem, Thanks for teaching me something. I didn’t know there was such a thing. I don’t quite understand how they work and the chart I looked at seems to have only a 90-day term structure.

    http://www.cmegroup.com/trading/equity-index/us-index/sp-500-dividend-index-futures.html

    So perhaps you can help me out with that. At any rate, future cash flows include not only dividends but also share buy-backs so dividend futures don’t exactly capture expected future cash flows. Finally, I was comparing the expected increase in future cash flows before and after the 2008 downturn, not saying that that there was no increase expected in future cash flows after the 2008 downturn.

    Benjamin (2), Did I say that? I don’t remember saying that.

    publicgood, Good catch. Thanks so much for mentioning it. I corrected it.

    kaleberg (2), Sorry, but just do say supply and demand doesn’t explain much. Stock buy backs increase the value of the remaining shares because each remaining share represents an increased claim on the future profits. But it’s still the expectation of future profits that governs what anyone will pay to own that future stream of payments.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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