Opinion Editorial | |
| Wednesday, September 2, 1998 | |
Stock Market Fall May Not Lead to Recession |
Last week's bloodbath in the stock market has some economists worried.
They are saying that this may signal the beginning of a recession and an
end to the longest economic expansion in American history. While the stock market is not an infallible indicator of economic conditions,
it is one that all economists pay attention to. The Standard & Poor's
500 stock index, for example, is one of the components of the Leading Economic
Indicators, a composite index of several economic measures that historically
have predicted the future direction of the economy. This index has now
fallen for two months and conventional wisdom suggests that three straight
declines forecast a recession. There are two main reasons why movements in the stock market may be a
valid indicator of economic conditions. First is that investors are future-oriented,
looking down the road at future profitability. A slowing economy leads
to lower profits. Thus widespread expectations of lower profits may indicate
slower economic growth. A second reason why the stock market may indicate future economic trends
is due to interaction between the economy and the stock market itself.
When stocks are rising, people feel wealthier. This leads them to save
less and spend more. Since consumption accounts for some two-thirds of
the economy, an increase in spending will tend to boost growth in the short
run. By contrast, a declining stock market will encourage consumers to
save more and cut back on spending, causing growth to slow. It is too soon to say whether a recession is definitely on the way.
Past stock market crashes, such as that in 1987, did not lead to recessions,
and the U.S. economy appears fundamentally strong, especially in comparison
to Asian and European economies. However, there is always risk of contagion,
as slower growth in Asia and Europe leads to reduced imports from the U.S.,
thereby slowing growth here. Asian and European companies may also try
harder to export their surplus goods to us, also reducing growth here. But the greatest risk is in financial markets. World financial markets
are more integrated today than they have been since before World War I.
Thus there is some risk that a serious financial collapse in a major country
such as Japan could spread through the world financial system and threaten
banks in the U.S. This is why U.S. markets have reacted to the financial
collapse taking place in Russia. Although not a major player in the world
financial system, markets fear a domino-effect that could cause Russia's
problems to spread to Europe and then to here. Something similar to this
happened in the 1980s when the collapse of a small bank in Oklahoma almost
brought down the giant Continental Illinois Bank in Chicago, which threatened
a system-wide banking crisis throughout the U.S. Our last line of defense against a system-wide collapse is the Federal
Reserve. It is what economists call the "lender of last resort."
In 1984, it bailed out Continental Illinois and prevented its problems
from spreading elsewhere. In the process the Fed was forced to abandon
its excessively tight monetary policy, which proved to be highly stimulative
to the economy as a whole. This suggests that there may be a silver lining behind the falling stock
market. It may force the Federal Reserve to ease monetary policy and reduce
short-term interest rates, a policy many economists have been advocating
for some time. These economists believe that deflation, not inflation,
should be the Fed's main concern now. Thus if a falling stock market causes
the Fed to ease, it may forestall a recession and keep growth on track. Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis,
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