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 about it.

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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