(cc photo: Aaron Goodman)
We are seeing the usual hysteria over the sharp drop in the markets in Asia, Europe, and perhaps the US. (Wall Street seems to be rallying as I write.) There are a few items worth noting as we enjoy the panic.
First and most importantly, the stock market is not the economy. The stock market has fluctuations all the time that have nothing to do with the real economy. The most famous was the 1987 crash, which did not correspond to any real-world bad event that anyone could identify.
Even over longer periods, there is no direct correlation between the stock market and GDP. In the decade of the 1970s, the stock market lost more than 40 percent of its value in real terms; in the decade of the 1980s it more than doubled. GDP growth averaged 3.3 percent from 1980 to 1990, compared to 3.2 percent from 1970 to 1980.
Apart from its erratic movements, the stock market is not even in principle supposed to be a measure of economic activity. It is supposed to represent the present value of future profits. This means that if people are expecting the economy to slow down, but also expect a big shift in income from wages to profits, then we should expect to see the market rise. So there is no sense in treating the stock market as a gauge of economic activity–it isn’t.
Turning to this specific downturn, it seems clear that the troubles in China are the immediate cause. I will claim zero expertise on China’s economy, but one thing seems very clear: It had a serious stock bubble. Its market rose by more than 60 percent from the start of the year to its peak in early June. At that point, it was more than 150 percent above its year-ago level. Even with the recent plunge, it is still more than 50 percent above the year-ago level.
It was inevitable that this bubble would burst; the only question was when. The collapse undoubtedly hurt some Chinese investors, many of whom recently entered the market, often with large amounts of leverage. The direct impact on the Chinese economy is likely to be limited; these people would not in aggregate have enough wealth so that any reduction in spending would hit the economy in a big way. (Remember, people who were in the market last year are still way ahead.) There may be a political issue here for the Chinese government, which apparently encouraged people to buy into the market.
And, contrary to the children’s tales about the purpose of the stock market, firms rarely finance investment through issuing shares. (The Internet bubble was an exception.) Shares are more typically issued so that early investors can cash out. So China’s investment is not likely to take a hit because of the market crash.
There is a larger issue for the Chinese economy about its ability to convert from an investment- and trade-driven economy to one driven by consumption. This is not an easy task, and it would not be surprising if China finds it difficult. I’ll leave it to people who are more expert than me to give odds, but we can say a bit about the impact on this switch (or its failure) on the US.
From the standpoint of the US economy, the main impact of a failed transition in China will be an increase in its trade surplus. A lower-valued Chinese currency will mean that it exports more and imports less. Also, slower GDP growth will be a drag on its imports. Let’s say that this effect raises its trade surplus by $200 billion above its baseline path, an amount equal to 10 percent of current imports.
If we assume that this increase in trade surplus is shared evenly between the US, Europe and the rest of the world, this implies an increase in the US trade deficit of roughly $70 billion. If we assume a multiplier on 1.5, that will reduce GDP growth over the next year by $105 billion, or a bit less than 0.6 percent.
A 0.6 percentage point hit to GDP is hardly trivial, but not the sort of thing that gives us another recession. I suppose the shift in China’s trade surplus could be even larger, but it is hard to imagine it would be too much larger.
It is also worth making a point that should be obvious: This is all a story of inadequate demand. In other words, our big problem is that we are not spending enough money. I know it would be wonderful if companies went on an investment spree, but this is not likely to happen, even if a Republican president and Congress give them all of our money. We may want consumers to spend more, but with savings rates at historic lows, that will not likely to happen. (People do need to save for retirement.)
This leaves trade and government spending as potential sources for increased demand. The trick to improving our trade balance is a lower-valued dollar. That’s a good long-term story, but hard to see much in this direction at the moment, with most other countries’ economies looking weaker than ours.
That leaves the big bad government: If we want more demand, it will have to come from the government paying for evil things like infrastructure, education, healthcare and green energy. But we all know weak growth and more unemployment is the better way to go.
Economist Dean Baker is co-director of the Center for Economic and Policy Research in Washington, DC. A version of this post originally appeared on CEPR’s blog Beat the Press (8/24/15).
From the “news” in 1987, top 10 reasons for October 19th, 1987 crash of the Ponzi-sche…uh, Stock Market!
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10. The First Case in an American court ruling on the validity of Surrogacy is declared by a New Jersey court over custody rights of “Baby M” re a surrogacy agreement with Mary Beth Whitehead
9. 1987 is shortened by 1 second to adjust to the Gregorian calender
8. Prozac makes its debut in the United States
7. Search for Nessie reveals no evidence after 1.6 million dollar investment
6. The USS Stark a Frigate is attacked on May 17th by an Iraq Air to Sea missile Which is “an Accident” (’cause it wasn’t Iran) and 37 US Sailors are killed
5. The US Population Estimated at 244.6 Million and The World’s Population reaches approx five billion (5,000,000,000) , 2 1/2 times the Planet’s capacity.
4. The Disney corporation and France agree to create an amusement park.
3. Margaret Thatcher is elected as Prime Minister of the United Kingdom for the third time
2. Alan Greenspan succeeds Paul Volcker as chairman of the Federal Reserve Board
And the NUMBER ONE REASON for the Market Crash of 1987:
1. Fox Broadcasting Co. made its prime-time TV debut
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And the number one reason why it didn’t cave in completely:
1. The Simpsons seen on TV for the first time
Why write big bad government when big government will suffice?
Why is it a problem if we are not spending enough money? We have been a spendthrift society, running up debt in both the private and public sector. While consumers may have been forced to cut down on some spending, government has had no such restraint since the creation of the IRS and the Federal Reserve..
The only sure way to stimulate demand is by increasing the income of the poor.
“People do not need to save for retirement”
What? Ok maybe if you said “ladies and gentlemen, most of which are very underpaid, live paycheck to paycheck, that is if you are lucky enough to have one minimum wage service job, and one of those that get get 30 hours a week, if you do not mind never retiring, never getting a raise, do not mind eating can’s of cat food when you are grandmothers and grandfathers and are comfortable moving your possessions in a shopping cart as apartment rental costs are fast let exceeding wages, and social security that you are due hardly offers a living wage-then perhaps you do not need to save for retirement yet even doing so might be fruitless when the coming bail-in for the next banking crisis of gambling, and ponzu schemes rob you of that savings the you might want to think about saving cash under your mattress” it would make sense.
@David Carswell
Dr. Baker wrote “(People do need to save for retirement ).” … .
Hello. Very good article. But can you explain why it is a demand problem for the United States? If we have a trade deficit isn’t that buying more and exporting less? How will it help if US government spends more, in relation to this problem?
@Dean Baker: ‘A 0.6 percentage point hit to GDP is hardly trivial, but not the sort of thing that gives us another recession. I suppose the shift in China’s trade surplus could be even larger, but it is hard to imagine it would be too much larger. It is also worth making a point that should be obvious: This is all a story of inadequate demand.’
@Tina Minkowitz: ‘can you explain why it is a demand problem for the United States?’
Baker’s transition was rather rough, so I’ll try to fill it in. There is widespread agreement (YMMV) that the US economy has generated insufficient growth in “recent years” (though the point of origin tends to vary), and that this growth clamp is somehow related to stagnation in incomes at the median level and below. The macroeconomic explanation I would give for this growth clamp, with which I suspect Baker would agree (ICBW), goes like this:
From ~1933 to ~1973 the US had moderate economic growth and moderate economic inequality. This had many causes, but was mostly due to the interaction between those 2 facts (levels of economic growth and inequality): simultaneously,
1. Owners of the “means of producion” in the US (aka “the 1%”) had enough capital to produce goods and services.
2. Everyone else (aka “the 99%”) had the money (aka “effective demand”[1]) with which to buy the 1%’s production. The US’ collective effective demand is called its “aggregate demand.”[2]
3. “The 99%” crucially also had the willingness to spend their increasing incomes (aka “high marginal propensity to consume”[3]) which maintained US aggregate demand at high levels relative to total product (aka GDP).
The US 1% found such moderation intolerable–see the Powell Memo[4] or any Ayn Rand novel for details :-) Now, the US has much greater inequality (which the 1% much prefers) but negligible growth, because the 1% are taking all the earnings from increased productivity but have low marginal propensity to consume, which depresses aggregate demand. This also contributes to financial-market volatility: too much capital is chasing too little “real economy,” causing speculative bubbles.
[1]: https://en.wikipedia.org/wiki/Effective_demand
[2]: https://en.wikipedia.org/wiki/Aggregate_demand
[3]: https://en.wikipedia.org/wiki/Lewis_F._Powell,_Jr.#Powell_Memorandum
[4]: https://en.wikipedia.org/wiki/Marginal_propensity_to_consume
Umm … reverse the order of those last 2 footnotes, since unfortunately there seems to be no UI for editing one’s comments once posted.
It appears that corporate stock buybacks have an interesting role here both in the stock market behavior as well as the disconnect from the real economy. To me it stinks of diminishing returns to investment, particularly when the spike in buybacks is coincidental with record high share prices. But, the other side of the story is that companies are spending so much on buybacks (often via debt financing) combined with paying out dividends, that they invest very little in tangibles that would actually improve the non-speculative aspects of their business and the economy. Executives are doubly incentivized to buoy stock prices when significant portions of their compensation is in stock and their performance is judged at least partially in earnings per share. We are at record levels as far as corporate buybacks are concerned with the last peak occurring just prior to the last financial crisis. Ironically enough, prior to experiencing a severe inability to obtain financing companies were spending record sums in repurchasing their stocks. Additionally, zero interest rate policies via the Federal Reserve have been allowing companies to engage in debt financed buybacks which are especially problematic. They have done so at a loss to cost to American operations (increasing leverage) while hoarding foreign earnings that can’t be repatriated without significant cost. The leverage may put them in a rather precarious position if markets take a rather substantial hit.
This article seems reasonable, but it is not clear to me that it is correct.
Sure, the stock market isn’t the economy. However, I would note that there has NEVER been a case where the stock market was tanking but the economy was strong. Thus it might well be a symptom, rather than a cause.
Secondly, the slowdown in China would likely have effects far beyond simple yuan depreciation. I just saw somewhere that BOTH US exports and imports are falling. Could it be that years of over-and malinvestment all over the world due to artificially suppressed interest rates, coupled with underpayment to Labor, are affecting consumer ability to spend?
Lastly, a fall in the stock market can be due to many causes. One cause which I think no one debates is what was noted above: 5 years of ZIRP plus a decade of very low interest rates before it. A massive asset and stock bubble?