About the author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
Economist Paul Samuelson famously quipped that the stock market had predicted nine out of the last five economic recessions. By this he meant that the stock market tends to be overly pessimistic about the economic outlook.
Before taking comfort in Samuelson’s quip, we might pause to think that there are good reasons to believe that this year’s stock market carnage could very well be one of those occasions. The stock market may well be proved right in thinking that a recession is around the corner. The ongoing stock market decline is now destroying household wealth on a scale that could weigh heavily on consumer and investor sentiment.
In gauging how seriously this year’s stock market’s decline might impact the economy, it is well to recall both how important the stock market has become and how precipitously the market has declined this year.
By the end of last year, fueled by a decade of ultra-easy Federal Reserve monetary policy, the stock market’s total value reached a record 200% of gross domestic product. This was around 50% higher than its pre-2008 peak.
Similarly impressive has been the size of the stock market’s recent decline. Since the start of this year, in the space of less than six months, the S&P 500 has declined by more than 20% while the tech-heavy Nasdaq has lost more than 30%. This means that over the past six months, more than $9 trillion in stock market household wealth has evaporated.
Particularly concerning is that the stock market’s decline has not been occurring in isolation. Unlike on previous occasions, the stock market’s decline is being accompanied by parallel large declines in the markets for bonds and other assets like cryptocurrencies. Since the start of the year, those losses combined with the stock market losses have resulted in the destruction of some $13 trillion in household wealth, or about 50% of what the U.S. economy produces in an entire year.
According to Federal Reserve estimates, for every $1 dollar decline in wealth, households tend to cut back spending by some 4 cents. This implies that if sustained, the recent loss of financial wealth could in itself involve a 2% cutback in household spending. This is the last thing that the U.S. economy needs at a time when consumer confidence has dropped to a record low. Households are grappling with 40-year high inflation at a time when the housing market is starting to crumble under the weight of a rapid spike in mortgage rates.
Another way in which the stock market can bring on an economic recession is by stressing the financial system. As Warren Buffett famously said, when the tide goes out, we find out who has been swimming naked. With the tide of easy money having gone out and with the stock and bond market plunging, it would seem to be only a matter of time before we see some dead bodies floating in hedge fund and equity fund land.
It has become fashionable among economists now to be worried about a wage-price spiral. This worry is likely soon to be eclipsed by worries about a stock market-recession spiral. We could soon find ourselves in a situation where declining stock prices produce a recession that brings on a further downward leg in the stock market. This worry would seem to be all the more relevant today, when an inflation-fighting Federal Reserve no longer has the market’s back with zero interest rates and ample money printing.
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