Posted: Jul 25, 2002 12:00 AM
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 economic growth. 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, people think. 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.