Summary: As so many of us expect, the US stock market might (might!) have begun the big rollover. If so, how might that affect the US economy? If you rely on the news, you’ll be surprised. Here’s a brief note; I’ll write more about this next week.
The decline of stock prices in China and America will produce the usual flood of clickbait. In fact stock prices have only minor effects on the economy. In the 25 May 1970 issue of Newsweek, 3 major economists gave their views. Friedman and Samuelson are Nobel Laureates.
Henry Wallich: “After 1929, the Dow Jones industrial average dropped by about 90%. I see nothing of the sort ahead. And even if the stock market suffered further reverses, the economy still would not be decisively affected.”
Milton Friedman: “The stock crash in 1929 was a momentous event, but it did not produce the Great Depression and it was not a major factor in the Depression’s severity. A sharp but not unprecedented contraction was converted into a catastrophe by bad monetary policy — one that permitted the quantity of money to decline by one-third from 1929 to 1933. Whatever happens to the stock market, it cannot lead to a great depression unless it produces or is accompanied by a monetary collapse. And with present institutions and present understanding, that is well – nigh impossible.”
Paul A. Samuelson: “{R}emember, in our economy, the market is the tail — and the tail does not wag the dog, which is gross national product. The decline has cut a quarter of a trillion dollars from people’s net worth and that will be a depressant, but not a major one, on consumption and investment spending.”
Also see this analysis by the Boston Fed from June 1971: longer, same conclusion. Not much has changed since.
(2) How might stock prices affect us?
A massive body of research since then has largely confirmed their opinions. Here’s a brief summary of the often named transmission belts from stock prices to the broad economy.
The “wealth effect”: People spend less because they have less wealth. In fact stock market wealth is highly concentrated among the wealthy, and their consumption varies only slightly with their wealth.
Consumer confidence: These are “hard” numbers published frequently, and so reliable clickbait generators. Assuming it can be measured accurately (questionable), there is little research showing that it has any effect. However, it might have a secondary effect. If journalists work themselves into a frenzy about this — or any indicator — their stories might influence the public’s willingness to spend and save.
Corporate investment and hiring: Many factors influence these decisions by CEO’s and CFO’s, which powerfully affect the economy. Interest rates (short term rates, time and credit premia), changes in tax laws, trends in revenue and profits, etc. Stock prices are not a major factor.
Losses by banks: Bank lending and bank solvency are among the most important factors. A depression usually requires a banking collapse. Radically different government policy in 1929-32 and 2008-09 made the difference between the Great Depression and the Great Recession (the initial economic declines were similar). But banks hold only trivial fraction of their assets in stocks.
Loses by investors on margin: Debt deflation caused by loan defaults can drive an economy into the ground. But loans against stocks are a trivial fraction of bank loans: loans on “other securities” (which include stocks) are $758 billion (7% of total bank credit). Margin loans by NYSE brokerage firms total only $505 billion. Note these are secured loans with recourse to the borrower (i.e., the borrower is liable for any losses).
What about secondary effects? This gets complex. The largest secondary effect — by far — might be on Federal Reserve monetary policy. Today that means on the Fed’s willingness to continue its Zero Interest Rate Policy (ZIRP), in effect since December 2008.
Important: saying the the American economy will not be serious affected does not mean that individual companies and regions will not be devastated. See the list of likely casualties here.
(3) Doesn’t the stock market forecast the economy?
Yes, somewhat. So do many other factors: shape of the yield curve, credit spreads, and a host of other leading indicators. How well these work can be seen in the failure of economists — see in surveys of consensus opinion such as the Blue Chip Financial Forecasts — to ever predict a recession (correctly or incorrectly).
Some economists saw a downturn coming, eventually arriving in 2008. Nobody (that I’ve found) saw the timing in useful fashion, or saw the accompanying bank collapse that created the Great Recession (consensus opinion was that the banks were in excellent shape; their senior managers also thought so).
Don’t believe you can do better.
(4) What about the stock market price crash in China?
The Shanghai stock exchange composite index is at 3,507 — up 10% YTD and 59% YoY. Did the journalists you read mention that? It’s down 32% from its June peak of 5,178, but such wild gyrations indicate a structurally broken market — delinked from meaningful economic fundamentals.
Could it really crash from here, back to the low 2,000-range it traded in from Summer 2012 to Summer 2014? Easily, or even probably. What effect would that have on China and the world? I doubt that anybody on this side of the Pacific knows, no matter how much confident guessing fills the news. I wonder if anyone in China has the necessary data and analytical tools to say.
(5) What’s going to happen next?
I’ve said that a major stock market crash is inevitable, although the timing is impossible to predict. But that’s a side show. Instead I recommend you watch unemployment claims, the monthly job report, and credit spreads.
The best forecasting tools still look positive (i.e., for continued slow growth): The Atlanta Fed’s GDPnow forecast and the Blue Chip Economists’ Forecast, Professor Jim Hamilton’s Econbrowser Recession Indicator Index, and the OECD’s Composite Leading Indicators (showing the major nations and regions).
I believe the US and world economy are weaker than believed by consensus opinion. Most important, I believe that at some point during the past decade or so we left the post-WWII era and began a transition to a new era. These transitions take decades (e.g., 1914-1950). All the “rules” change, making reliable forecasts impossible.
Stay tuned for more about this next week.
“Unless you expect the unexpected you will never find truth, for it is difficult to discover.”
— Heraclitus, the pre-Socratic “Weeping Philosopher” of Ionia.
(6) For More Information
If you liked this post, like us on Facebook and follow us on Twitter. See all posts about the economy, about financial bubbles, and especially these…
- The new tech bubble takes us to a new world. A mad world.
- How we’ve become accustomed to bubbles bursting the economy, instead of fighting them.
- We see a stock market bubble but prefer to close our eyes.
- Don’t ask if there’s a biotech bubble. Ask why we have another bubble.
- The key things to know about the great American bubble machine.
- When you look back on this day & remember the bubble…
(7) Great books about bubbles
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Low wages, low productivity, trillions of net profit off-shored, low GDP and the list goes on and on equals a whole lot of uncertainty.
Ron,
True. I have been doing this for 33 years, and in every one of those years there was a similar or longer list of challenges.
We have analytic tools because listing problems tells us little. We need to know their magnitude, likelihood over a relevant time horizon, and interdependencies (i.e., what might knock them down and what they might knock down).
Thank for your response. I wonder if the greatest paradox of economics is; how does a nation succeed with modest consumption (unlimited wants and finite resources the concern) and stable job growth? Can we have a healthy economy without over-consumption?
Ron,
I don’t understand. What is metric defining over- or underconsumption? Consumption vs what?
Good article, FM.
One thing you did not directly address is that the stock market has become increasingly disconnected from the “real world” by all of the cash that has been pumped into it and the actions of a lot of different people and organizations for their own reasons.
The original purpose of stock markets was to help fund corporations and to easily collect the benefits from ownership (either from selling your shares of stock or collecting dividends from your shares). For quite a lot of reasons, both good and bad, the stock market has become a massive game of chance that has less and less to do with careful investment practices (although those still work well enough for patient well-educated investors) and more and more about hype and high velocity trading designed to squeeze massive quantities of cash from the unwary and the unlucky, one trade at a time. As a result it has become increasingly difficult to say what effect Wall Street has on Main Street.
Furthermore, many of the things that have been done in the market since 2008 were designed to protect investors from downturns in the real world. That may or may not work in both directions.
Pluto,
I agree about the disconnect — the extreme valuation. But I have written about that many times. It no longer matters. To use a bad analogy, when the roller coaster reaches the top of the track, it no longer matters why you got into the car.
“The original purpose of stock markets was to help fund corporations and to easily collect the benefits from ownership”
The first has always been the least important. The third purpose has always been important, and for long has been the most important: a medium for transferring ownership. So, as with housing, those who own the transfer machinery dominate how the game is seen and run.
Re: protections implemented since 2008
They are probably less important than those from the New Deal that were dismantled during the Clinton-Bush years.
So Fm has been at this for 33 years. Pay attention here.
“The first has always been the least important. The third purpose has always been important, and for long has been the most important: a medium for transferring ownership. So, as with housing, those who own the transfer machinery dominate how the game is seen and run.”
I have a friend, he told me way back, that when he became a Comm RE developer he thought the business was about bricks and mortars. He discovered it was really about finance and tax codes. He thought he had it figured out. One day he realized …no, he was in the wrong business! The guys who provided the finance ….well.
Pay no attention to the Stock Market, per se. It’s like the shadows in a Platos Cave. Or maybe we are in the wrong business?
Breton
Breton,
I recall a story by the legendary investor Marc Faber. During the 1970s bear market he visited a banker in Austria. Faber asked his opinion of the local stocks. The banker replied “We still have a stock market?” Equity markets are often a backwater in a nation’s financial system, and even more so in its society. Perhaps it’s best that way.
But finance plays an important role in society — banks, financial markets, lending, venture capital — and markets in financial securities make them work well. Also, their fluctuations as as a form of shock absorber protecting the real economy.
Unfortunately markets — especially of stocks — are inherently prone to boom and bust cycles (these are easy to produce in a classroom exercise). These can be large. The 1970s equities bear market ending in August 1982 brought the real value of US equities back to roughly 1964 values. It burned away — along with structural changes — roughly half the jobs in the industry (narrowly defined). I believe the next bear market will do the same to the current industry.
Back to the subject here — Unless managed by adequate regulations (self-reg or gov’t reg) fluctuations in equity prices can have ill effects on the real economy. The limits on lending by banks and brokers against stock as collateral are the most important — and work well in America. Hence my conclusion that the direct and short-term macroeconomic effects of a crash are minor.
I have another friend. He told me once he was too busy right now but we would do this Project later in the first quarter.
And so we did. He later asked if I had heard about this frozen burrito company. Yeah. And they were sold to some Dow assemblage, right? Yes. And that stock had taken a few downgrades. Yes. Well he was in the right business. He had funded and assumed a majority interest in the wonderful frozen burrito firm.
The Purchaser and its stockholders were in the wrong business. This goes on day after day and Jim Cramer goes on TV the same amount of time.
Breton
FM….I seriously laughed at your comment! The Bankers reply, that is. And I am not offering an Ethical position here. And respect all you say in following, do agree in toto.
I’m just saying….watch what you pay attention to. Click bait.
Breton
Breton,
The internet is becoming dominated by clickbait, in the sense of material appealing to (pushing the buttons of) a specific tribe. Broader based sources, like the FM website, are being annihilated. I see this in our traffic. We run themes. Recently articles have featured right-wing propaganda, police violence, and growing inequality — so we’ve built a audience on the Left. Two weeks of posts about the IPCC’s rebuttals of climate activists — bang! They’re gone. Like spraying holy water at a vampire party. Traffic from the West coast (i.e., 6-11 PST) dropped by half.
Clickbait = tell me what I want to hear. It’s the info for an easily manipulated people.
Reblogged this on ΕΝΙΑΙΟ ΜΕΤΩΠΟ ΠΑΙΔΕΙΑΣ.
Great blog and current article!! The criminal 1% oligarchy around the world will throw a hissy-fit when their perceived “wealth” is reduced by stock market losses. They will take it out on the 99% by firing people and drastically reducing business investment and general activities. Then many more people will not have jobs and income to pay mortgages, rents, credit cards, student loans and auto loans. Thus the carnage will begin within the next 6-12 months and it could last years. How many stocks and worthless loans can central bankers purchase? Remember money-currency and income are interrelated legal and accounting fictions. Those things that are finite on this earth are people, resources, and the environment – the rest we create out of nothing and use those fictions to enslave ourselves. People need to invest in themselves locally and around the world – but not in dysfunctional and corrupt governments, banks, corporations (and other legal fictions). They should visit the new WGO educational and advocacy website here: “http://www.i-globals.org” to see how people can quickly, legally and powerfully cooperate to create their own universal basic income via a new private debt-free digital currency. We need to think and act outside the broken, corrupt and collapsing status quo Matrix and the WGO provides a viable alternative. Best wishes to all in these challenging times.
P77,
I doubt the 1% cate about fluctuations in the stock market. Does Bill Gates care if he is worth $60 or $80 billion?
CEO/ don’t care, either. Corporate capex and hiring does not fluctuate with the level of the stock market.
Watch the real economy. That is center ring of the circus.
Interesting subject. You are right. The stock market has very little to do with the economy. You have heard that the market does best when blood is running in the streets. When the economy is in a serious depression, the stock market will be in a bull mkt.
I think that the stock market has two relationships with economic reality, though not as a real influence on the economy.
First, the govt has a mandate to ensure that the stock market does well. This is so the pretty evening news anchor can ensure workers that the countries economy is doing well. The stock market is up, new and existing median home prices are rising. Unemployment is dropping. The workers can go to bed and get a good night sleep; the economy is doing ok and getting better. Best that they not know the real truth. They might not be motivated to get up in the morning and join the rat race.
Secondly, I agree with you that the US stock market will enter a long and persistant bear market. Maybe not a stock market crash, but a severe bear mkt none the less. Current book values are way over valued. You can buy a Certified major gold mine that makes a profit right now for book. Just to show how whacky the P/B ratios are for most common stocks now.
How does this relate to the economy? Remember the stock crash of ’29? What happened after that? The same thing will happen to to economy this time as well.
Folks will ask, Why didn’t we see it coming? Because they were listening to the pretty news anchor on the nightly news. And, oh btw, There have been 84,000 job layoffs just in the energy sector so far this year in the US. Energy sector CEO’s are predicting another 75, 000 to 100, 000 layoffs in the energy sector next year. That adds up to approx. 200, 000 layoffs in the energy sector alone in the US. The energy workers make real good wages. With the trickle down effect of all of these layoffs on the general economy, we are looking at over a half a million layoffs in the US. The pretty news anchor is not allowed to share this reality with the public.
The general public will not understand why there is such a huge sell off in equities. Can you say Good bye retirement account?
Nor will they realize what such a loss in the equity markets portend to come.
Kev,
You obviously have a good grasp of these matters. For the benefit of readers I’ll provide a bit more detail on a few points.
“You have heard that the market does best when blood is running in the streets.”
More precisely, that’s when the market hits bottom — the point to buy. Gains come later, for the solvent and patient.
“When the economy is in a serious depression, the stock market will be in a bull mkt.”
That’s based on US experience in our only modern depression — the 1930s (the stock market of the late 19th century had little in common with ours, except for the location in NY). The massive bull market was caused not by the depression but by government action: the recovery after FBR closed the banks in 1933 and began the New Deal. As the brilliant Roger Ibbotson showed, bear markets often take markets to zero. The US has avoided this, so far — but our experience should not be generalized to other times and places, including our future.
“Why didn’t we see it coming?”
I agree. That will be the big question. If we have a crash, that will be the 3rd since 1999, vs our usual experience of once per generation. Even the public will realize that something is broken in the system. I believe that radical change might follow, on a scale impossible to believe today.
Editor, you keep referring to a probable stock market “crash”. I would not be surprised to see no major market “crash”. Just a looong, persistant bear market that wipes out over 50% of the market cap. But crash or long term bear mkt, the end results will be the same.
So you feel that Joe Public will realize that something is wrong with the system. Most folks know that there is a LOT wrong with the system. But general apathy in america has never been higher.
I am apolitical and not for nor against any of the presidential candidates. But Donald Trumps main platform seems to be WAKE UP PEOPLE!
So maybe a historical event of this magnitude will help Joe Public start caring and standing up for what is right. But I doubt it. Ignorence is bliss. Most people will rather live a comfortable illusion than suffer the truth. But you are right about one thing: Huge changes are going to occur. Maybe even a new US currency!
Kev,
“Just a looong, persistant bear market that wipes out over 50% of the market cap.”
For structural reasons, periods of overvaluation always end with a crash, not slow declines. As they say, due to gravity markets fall faster than they rise. More technically, rising markets tend to gain liquidity. Falling markets lose liquidity (i.e. buyers), so the incremental seller must discount more to find a buyer. Also, there is not equivalent in rising markets to margin selling — forced selling at the market to meet margin calls.
“So maybe a historical event of this magnitude”
I don’t expect a historic event in magnitude, just a typical crash. What would be historic is that this would be the 3rd in one generation. People are apathetic imo because they feel disconnected from events on the grand stage. Take their money and they feel involved. This is, of course, just a guess.
I don’t expect us to draw useful larger lessons. Such as 3 crashes in one generation means that we’re slow and stupid — “sins” that Nature’s God always punishes. Realization of that might prompt serious reform.
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When a stock market crashes it’s a sudden dramatic decline of stock prices across a significant cross-section of a stock market. It is caused by resulting in a significant loss of paper wealth.
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