The sharp fall in the stock market is wreaking havoc with
economic forecasts these days. Economists cannot decide whether it means
something or nothing. And if it means something, they are not sure if it is
a cause or an effect.
On the one hand, the stock market is presumed to be a
forward-looking indicator. In theory, market participants make a bet on
whether the economy -- and therefore corporate earnings -- will be rising in
the near future or falling. Consequently, a falling stock market might
indicate a belief on their part that prospects for the economy and earnings
are poor. Since they are betting their own money on their judgment, one has
to give serious consideration to the possibility that they are right.
The problem is that they are often wrong. There have been many
occasions when the stock market fell sharply without a following recession.
According to economist Brian Nottage, there have been 15 "bear markets"
since 1929, where stock prices fell for an extended period of time. But
almost half were not associated with a subsequent recession. The stock
market fell sharply in 1987 and 1998, for example, without any meaningful
impact on the real economy.
An alternative view is that the stock market may be a poor
predictor, but nevertheless may affect subsequent economic activity on its
own. That is, a fall in the stock market may so erode personal wealth that
individuals will stop spending. Since consumption represents about
two-thirds of GDP, even small changes in consumer spending can affect
Economists call this the "wealth effect" and spend a lot of time
studying it. The Federal Reserve was strongly influenced by research in this
area to tighten monetary policy in 1999. It thought that people were
becoming too rich and that this would translate into higher spending, which
would put upward pressure on productive capacity and cause inflation. This
led the Fed to raise interest rates in a conscious effort to "prick" the
stock market bubble and head off a rise in spending and inflation.
My view has been that if the stock market was in some kind of
unsustainable "bubble," resulting from "irrational exuberance" -- to use
Alan Greenspan's phrase -- then sooner or later it would have corrected
itself. Policymakers have no business second-guessing the market and making
their own judgments about whether the market is too high. Only people
risking their own money have that right.
The Fed's concern is only legitimate if there is a meaningful
correlation between stock prices and consumer prices. But the evidence
supporting such a relationship is extremely tenuous. To the extent that it
operates at all, it must be through higher stock prices causing an increase
in consumption. That is, people spending their higher wealth on cars,
clothes and other consumer goods.
Some studies find relatively large effects on spending from
changes in wealth, others find very little. But even those that find large
effects report increases in spending of just 5 cents to 6 cents for every $1
increase in wealth.
One reason for the contrary findings may be that, prior to 1978,
when the 401(k) account was created, most stocks were held in ordinary
brokerage accounts. People had easy access to funds in them. But 401(k)'s
are designed for retirement saving. The size of such accounts may affect
retirement behavior, but probably don't affect current consumption, because
people can only withdraw funds from them by paying a substantial penalty.
In any case, for those in the middle class, wealth is primarily
in housing, which has done very well even as the stock market has fallen.
For many people, their houses have increased in value by more than their
stocks have fallen. Since the wealthy own most stocks, they are the ones who
have suffered most. But since they are wealthy, it is doubtful that they
changed their spending much on the way up or on the way down. Therefore, the
economy as a whole is largely unaffected.
The impact of the falling stock market is mainly psychological.
When people lose money -- even money they never expected to spend -- they
feel bad. This may cause them to retaliate against those whom they believe
are responsible -- generally, the political party in power. Even if it
didn't cause the losses, it should have done something to prevent them,
Thus the impact of the fall in the stock market is more likely
to be on elections than on the economy. I believe that the economy is
fundamentally strong and is unconnected to the stock market's problems. But
if stocks do not rebound before November, Republicans in Congress could
still pay the price.