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
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