Market decline

Stock market drop could drive real economy into recession

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Traders work at the New York Stock Exchange, Monday, June 13, 2022. The last thing the U.S. economy needs is a drop in consumer spending driven by the market downturn, writes Desmond Lachman.

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About the Author: Desmond Lachman is a Senior Fellow at the American Enterprise Institute. He was previously Deputy Director of the Policy Development and Review Department at the International Monetary Fund and Chief Emerging Markets Economic Strategist at Salomon Smith Barney.

Economist Paul Samuelson joked that the stock market predicted nine of the last five economic recessions. By this he meant that the stock market tends to be overly pessimistic about the economic outlook.

Before we take comfort in Samuelson’s quip, we might pause to think that there’s good reason to believe that this year’s stock market carnage could very well be one of those occasions. The stock market may well be right to believe that a recession is imminent. The continued decline in stock markets is now destroying household wealth on a scale that could weigh heavily on consumer and investor sentiment.

In assessing how much this year’s stock market decline could impact the economy, it’s worth remembering both how big the stock market has become and how much the market has fallen this year.

Late last year, fueled by a decade of ultra-loose monetary policy from the Federal Reserve, the total value of the stock market hit a record high of 200% of gross domestic product. That was about 50% higher than its pre-2008 peak.

The magnitude of the recent stock market decline is equally impressive. Since the beginning of this year, in less than six months, the S&P 500 has decreases more than 20% while the tech-heavy Nasdaq lost more than 30%. This means that over the past six months, more than $9 trillion of stock market household wealth has evaporated.

What is particularly worrisome is that the stock market decline did not occur in isolation. Unlike previous occasions, the decline in the stock market is accompanied by parallel steep declines in bond markets and other assets like cryptocurrencies. Year-to-date, these losses combined with stock market losses have resulted in the destruction of some $13 trillion in household wealth, or about 50% of what the US economy produces in an entire year.

According to Federal Reserve estimates, for every $1 drop in wealth, households tend to cut spending by about 4 cents. This implies that, if prolonged, the recent loss of financial wealth could in itself lead to a 2% reduction in household spending. It’s the last thing the US economy needs at a time when consumer confidence has fallen to an all-time low. Households have been struggling with high inflation for 40 years at a time when the housing market is beginning to collapse under the weight of rapidly rising mortgage rates.

Another way the stock market can cause an economic downturn is through its stress on the financial system. As Warren Buffett so aptly said, when the tide goes out, we find out who swam naked. With the tide of easy money dying out and with the stock and bond markets falling, it seems only a matter of time before we see corpses floating around in hedge funds and equity funds. .

It is now fashionable among economists to worry about a wage-price spiral. This concern should soon be eclipsed by fears of a spiraling stock market recession. We may soon find ourselves in a situation where falling stock prices produce a recession that causes the stock market to fall further. This concern would seem all the more relevant today, when an inflation-fighting Federal Reserve no longer has the back of the market with zero interest rates and abundant money printing.

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