October 19, 1989
"Wall Street Crashes are Overrated"
San Jose Mercury News
By Timothy Taylor
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I'M beginning to think that stock market crashes are overrated.
The Dow Jones Industrial Average fell by 190 points last Friday, making the
stock market into a front-page Mercury News story for five days afterward. The
weekend news stories discussed the possibility of a total collapse of the stock
market on Monday; one headline read, "Trading on Monday will tell all."
Well, the Dow rose 88 points on Monday. As an economic horror story, it appears
that "Friday the 13th: The Stock Market Crash" will be a real yawner.
Two years ago today, the Dow fell by 508 points, its largest one-day drop ever.
There were proposals to ban various sorts of computer trading and shut down the
market if it moved too quickly. Predictions that the crash would lead to recession
and economic collapse were commonplace.
But the economy has kept right on trucking; it has now been almost seven full
years since the last recession. The stock market has climbed back to near-record
levels. For most average people, whose main interest in stocks is that their pension
funds have enough assets for them when they retire, the crash of 1987 has not
been relevant to their lives.
In fact, even the famous crash of 1929 that preceded the Great Depression 60
years ago appears to be overrated, at least in retrospect. The popular myth is
that the crash of October 1929 either foretold the Depression or caused it.
But economic historians are challenging the myth. A useful summary of the evidence
about the effects of the 1929 crash was provided in a staff study of the Presidential
Task Force on Market Mechanisms, headed by Nicholas Brady, which was set up in
the aftermath of the 1987 crash.
Among the findings of the task force: Only 6 percent of all households owned
stock in 1929, so only that many would have been directly affected by the crash.
The decline in consumption due to the 1929 crash was estimated at only one-half
of 1 percent of GNP. The crash of 1929 did not cause the crash of the banking
system, which remained in fairly good shape until 1933. Investment did not fall
sharply after the crash. Indeed, the stock market had fallen just as sharply in
1920 as in 1929, but the economy then recovered and grew rapidly through the rest
of the Roaring '20s, rather than falling into recession.
The task force's bottom line: "The Great Depression appears to have been
caused not by the stock market crash but by the interaction of a number of diverse
circumstances (such as the declines in agriculture and housing) and misguided
policies (such as the Smoot-Hawley tariff, the tight monetary policy in late 1931
and the tax increase in the summer of 1932)."
This fact that stock market crashes seem to have only minor effects on consumption
and investment in the rest of the economy should not be surprising, if you think
A stock market crash reduces wealth, in the same way that a fall in housing
prices would reduce wealth. But if housing prices fall 10 percent in Santa Clara
County next year, as some are predicting, what will really change? The same factories
will be here (earthquakes permitting), and people's take-home pay won't be affected.
The Brady task force cites estimates that on average, a decline of $100 in
stock prices is associated with only about a $5 decline in current consumption.
Even that low figure may overstate how much people react to crashes. Since most
crashes are preceded by sharp increases in price, stockholders (or homeowners)
are only losing a portion of their recently acquired gains, which is hardly likely
to cause an economic collapse.
In principle, a stock market crash also makes it more costly for corporations
to raise money by selling stock, and thus makes it harder for them to finance
new investments in plant and equipment. But most established corporations do not
raise money by selling additional stock; they do it by borrowing.
In addition, the statistical correlations between stock market crashes, consumption
and investment don't prove that stock market crashes are the root cause. As the
Brady task force argued, it is more plausible that the fall in confidence that
triggers the stock market crash also leads to mild declines in consumption and
investment. But the stock market crash is only a symptom of underlying economic
causes, not a separate cause in and of itself.
Stock market crashes make such a stir not because they affect the rest of the
economy, but because of their entertainment value. Watching someone make and lose
a lot of money in a short time can be kind of fun, whether it's on a game show
or on Wall Street. Economic soothsayers can draw fun little charts, as if they
were astrologers, and fulminate over how the world should follow their advice.
It's all fun, but it's mainly a sideshow. Stock market crashes are just ephemeral
bubbles; over time, the real economy determines the level of the stock market,
not the other way around.
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