Sep 17 2008

So the stock markets are crashing, what’s the big deal?

How Does the Stock Market Effect The Economy? | Economics Blog

Well, a few things… Generally, the fluctuations of the stock market do not necessarily bode ill for the whole economy. Likewise, global fluctuations of stock markets does not mean there is a recession on the horizon. In fact, an old adage says that “stock markets have predicted ten out of the last three recessions.” In other words, a slump in global markets does not always precipitate a slump in the world’s economy. Here’s some impacts the market crashes of the last few days may have, however, explained nicely by Richard Pettinger, an economics teacher in the UK:

Economic Effects of Stock Market

1. Wealth Effect: The first impact is that people with shares will see a fall in their wealth. If the fall is significant it will affect their financial outlook. If they are losing money on shares they will be more hesitant to spend money; this can contribute to a fall in consumer spending. However, the effect should not be given too much importance. Often people who buy shares are prepared to lose money; their spending patterns are usually independent of share prices, especially for short term losses.

2. Effect on Pensions: Anybody with a private pension or investment trust will be affected by the stock market, at least indirectly. Pension funds invest a significant part of their funds on the stock market. Therefore, if there is a serious fall in share prices, it reduces the value of pension funds. This means that future pension payouts will be lower. If share prices fall too much, pension funds can struggle to meet their promises. The important thing is the long term movements in the share prices. If share prices fall for a long time then it will definitely affect pension funds and future payouts.

3. Confidence: Often share price movements are reflections of what is happening in the economy. E.g. recent falls are based on fears of a US recession and global slowdown. However, the stock market itself can affect consumer confidence. Bad headlines of falling share prices are another factor which discourage people from spending. On its own it may not have much effect, but combined with falling house prices, share prices can be a discouraging factor.

4. Investment: Falling share prices can hamper firms ability to raise finance on the stock market. Firms who are expanding and wish to borrow often do so by issuing more shares – it provides a low cost way of borrowing more money. However, with falling share prices it becomes much more difficult.

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

7 responses so far

7 Responses to “So the stock markets are crashing, what’s the big deal?”

  1. James Tsaoon 26 Jan 2008 at 11:28 pm

    So even though the stock market is not counted as part of the GDP because it is merely a transfer of money, it CAN impact GDP. In terms of consumer confidence, the stock market does have great influence. This is why my parents believe that when shareholder confidence is low from a plummeting stock market, you can take advantage of it by acquiring stock that are very cheap. In the end, unless some thing BIG really happens, the stock market will go back up.

    I have a question though. How does the fiscal policy work if tax cuts are implemented at the same time the government increases its spending? Where does the government get the money?

  2. Jason Welkeron 27 Jan 2008 at 3:08 am

    Ah ha… the government borrows the money… from your parents, from foreigners, from firms and banks, from all sorts of places! don't worry, we'll talk all about that!

  3. Helenon 01 Feb 2008 at 6:24 pm

    It's funny: “stock markets have predicted ten out of the last three recessions”. Almost the whole world (the majority that hasn't taken economics) is staring the jagged lines go up and down, worried about the economy one second, then ecstatic the next, when it turns out that stock markets aren't that accurate of a predictor of the economy.

    The stock market apparently is the new "it" thing in China. My grandparents are buying them; my ayi is buying them; my dad even told me that his employees are checking the stock market every five seconds on their computers "behind his back". I'm not implying that these people are stupid, but overall, the percentage of people investing in stocks in China AND knowing what they're doing is becoming smaller and smaller. These sorts of "blind" investments ("my friend is buying that stock so I'll buy that too") – are they healthy for the economy?

  4. Leo Summerson 16 Feb 2008 at 11:46 pm

    It's a huge myth that anyone can second-guess the market. The reality is, no one can accurately and consistently predict where a market – or an individual stock – will go next.

    That's why smart investors and traders position themselves in such a way to take advantage of big market moves, without really caring whether the move is up or down.

    Anything else is just gambling.

  5. Steve Latteron 18 Sep 2008 at 7:50 am

    Hey Leo,

    You are going to be a rich man one day! Only the fools (or the rich who can afford to lose money) "play the stock market" (buy & sell) on a daily, weekly, or yearly basis.

    The real experts "buy & hold", "diversify" among many stocks, and laugh at the novices buying and selling stocks on a daily basis. Research confirms, based on tax return review, that the worst type of stock investor is the "day trader" or the investor that believes they can make money in the stock market on a short-term basis by frequent buying and selling. If you think about it all of these volatile "ups & downs" in the stock market these days are driven by "professionals" which is pretty sad. Independent reports show that over 70% of professional stock managers fail to outperform the average of the stock market because they buy and sell too often. Look into "index funds" as the way to invest. that is my best advice, but a story for a different day (or really a different blog site).

    Jason picked a good blog posting because stock market gyrations are on everyones mind these days!

  6. Elizabeth Wargoon 20 Sep 2008 at 9:07 am

    Up and down and up again. Remember that wall street is only a small part of the $14 trillion dollar US economy. The only problem is, it holds the ability to support the "buy now pay later" US mentality. In Asia where the mentality is largely "save now buy later" the opposite at times like these you can see why things like the Shanghai market rising over 9% yesterday (Friday September 19th) are happening. They have lots of cash "in there pockets" and need put it somewhere.

    I just may go out on a limb and say- that in my opinion, the U.S. may no longer be looked at by the world as the benchmark for capitalism.

  7. Christian Evertzon 29 Sep 2008 at 10:13 pm

    I don't think think that falling stocks necessarily mean that the economy is doing bad. Remember its only humans who sell and buy stocks and they might have different predictions or fears for the future. However, there is still some truth in what the stocks tell us, since stocks reflect the opinions of many people. Still, stocks of companies who are doing really well can fall, because people fear that the company will do bad in the future. So stocks give us a future outlook and do not always reflect what's currently happening in the economy.