Jan 22 2008
While Americans enjoyed a national holiday in honor of Martin Luther King yesterday, its stock markets remained closed. Elsewhere, however, stock markets from Asia to India to Europe to the UK experienced the worst one-day fall since 9/11. London’s FTSE fell more on Monday than it had since 1983. In Germany the market fell 7.2%. Here in Asia the picture was equally as dismal:
In Asia, Indian shares on Monday ended 7.4 per cent lower, and trading was halted in Mumbai after the market fell 9.8 per cent in the opening minutes; Hong Kong closed down 5.5 per cent; and Japan’s Nikkei average slid nearly 4 per cent, falling a further 4.4 per cent by midday on Tuesday while South Korea’s Kospi index lost a further 3.9 per cent. In the morning session on Tuesday, Hong Kong skidded another 8 per cent while Shanghai was down over 4 per cent. Indonesian shares sank 8 per cent in morning action.
In one day, literally trillions of dollars was lost in the value of the world’s stock markets; many are already referring to yesterday as Black Monday.
So, what does a global slide in stock markets have to do with macroeconomics? Interestingly, the events in the world’s stock markets tell a story about the interconnectedness of national economies in our era of globalization and international trade.
As some of my students may know, over the last year the housing market in the United States has experienced a massive slow-down. For years banks and lending agencies had been making loans to Americans with very poor or no credit history to buy houses. These “sub-prime” loans often came with variable interest rates, meaning that after a few years, the initial, attractively low interest rate would be notched up, adding significant amounts to the monthly payments owed by the borrowers, many of whom were forced to settle for a sub-prime loan because of their tenuous financial standing in the first place.
The results of this type of lending are predictable, and sure enough over the last year millions of Americans have defaulted on their home loans (mortgages) and the banks and institutions that made the loans have subsequently fallen into hard times. Today, America is experiencing a “credit crunch”, meaning that it’s harder than ever for consumers and firms to get loans from the bank, since banks are now more leery about lending to borrowers who may default on their loans. Less borrowing means less spending and investment, meaning the overall level of economic activity in America has slowed down; a sign that a recession may be on the horizon.
Recession, in macroeconomics, refers to anytime there are two consecutive quarters of negative economic growth. In other words, if the economy produces less total output now than it did a few months ago, it might be in a recession. Recessions are usually accompanied by rising unemployment and low consumer spending. Firms considering new investments in capital pay close attention to news of a recession, and similarly investors in stock markets pay close attention to the level of investments made by firms. When investors think firms are likely to expand and acquire new capital due to a positive business climate, investors tend to buy stock, driving up the value of the stock markets. On the other hand, when investors fear an economic slowdown, when consumers stop buying and firms stop investing, the investors themselves sell their stocks and switch their wealth to other assets.
So here’s another question: Why does the fear of a recession in the United States trigger a slump in the stock markets of other countries, from Asia to Europe? The answer here is that America, with its truly gigantic economy, is the largest trading partner of many of the world’s developed economies. If consumers in America stop buying goods and services, not only American firms suffer, but Chinese, Japanese, Southeast Asian, Indian and European firms alike may suffer as their largest trading partner slides towards recession. This phenomenon is called “coupling” and refers to the dependency of many nations on the United States as a destination for its goods and services.
Back to our original question: What does the stock market sell-off have to do with macroeconomics. Here’s the quick answer: Macroeconomic policies aim to achieve three broad goals:
- Price-level stability, and
- Economic growth
The stock market plunge of “Black Monday” may signal an imminent recession not only in the US, but in the countries that depend on American consumers for their own economic strength (such as China). A global economic slowdown will have a significant human cost, in the form of high unemployment, often accompanied itself by political and social instability.
While we await the opening of the American stock market later today, we can rest assured that politicians and bankers are already considering steps that may help ward off further plunges in the markets and the economic slowdown they seem to foreshadow. Using expansionary fiscal policy, involving the lowering of taxes and increases in government spending, President Bush has already announced his plans to inject $150 into the US economy, hoping to encourage households and firms to spend more on goods and services. Additionally, America’s central bank, the Federal Reserve, has pursued expansionary monetary policy in the form of lowering interest rates, also in an attempt to encourage more borrowing and spending by households and firms.
Fiscal and monetary policies are both used to attempt to achieve the three goals identified above. Throughout the coming semester, in AP Economics, we will learn all about these goals and the tools used by policymakers to try and achieve them.
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