Let’s Not Draw Broad Conclusions From the Stock Market...

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ECONOMY AUGUST 27, 2011

Let’s Not Draw Broad Conclusions From the Stock Market Turmoil

This article is a contribution to 'Is There Anything That Can Be Done? A TNR Symposium On The Economy.' Click here to read other contributions to the series.

Most adults know that there is no Santa Claus. They should also know that there was no stock market crash associated with Standard and Poor’s downgrade of U.S. government debt. However, because powerful interests want to spread misinformation about the downgrade, people are likely to be much better informed about Santa Claus. Righting public perception about this recent history isn’t just an idle exercise—it’s the only way to keep our social welfare programs off the chopping block.

Once the S&P downgrade happened, politicians were quick to link the agency’s decision to the tumult in the stock market. However, a little common sense shows that this chain of logic is simply not true. The S&P downgrade was most immediately a statement that U.S. government debt is more risky than had previously been believed. If anyone took S&P seriously, then it would mean that they attach a higher risk premium to holding U.S. government debt. This is the exact opposite of how the financial markets reacted, however. Bond prices soared as the yields on U.S. Treasury bonds fell to near record lows. It was as though the markets with one loud yell screamed out “we spit on your downgrade, S&P!”

So why did the stock market plunge on Monday? Most people in Washington don’t know about it, but there is a currency across the Atlantic called the “euro.” The euro was on the edge of collapse because the debt crisis that was affecting some of the smaller governments was spreading to eurozone giants such as Spain and Italy. It will be very expensive to support the debt of these countries. On the other hand, if they are allowed to default it would be a massive blow to the European banking system. This would likely set off the same sort of chain reaction and freezing up of the financial system that we saw after Lehman collapsed in September of 2008. It is not surprising that the very realistic fear of another worldwide financial collapse would send the stock market tumbling.

Instead of accepting these basic facts, however, many politicians and people in the media were anxious to push the downgrade-market crash story to advance their agenda. The moral of their story is that we got a huge market plunge because we did not reduce our deficits enough, forcing S&P to downgrade the government. If we don’t straighten up and take our medicine, then S&P or one of the other credit agencies may do it again, and then we will get an even bigger market hit.

This narrative quickly leads to the conclusion that we have to cut Social Security, Medicare, and Medicaid, the huge social welfare programs that most of the working population either depends on now or expects to in their retirement. These are hugely popular programs among people of all ideologies, including Tea Party Republicans. Few politicians want to be associated with major cuts, but if the markets will crash unless they do something, then there really is no choice.

As a practical matter, the stock market actually has little impact on the economy. Firms rarely rely on stock issues to directly raise capital for investment. More typically, shares are issued to allow the original investors to cash out. The main impact of the stock market on the economy is through its effect on consumption. Economists generally estimate that an additional dollar in stock wealth will lead to 3-4 cents in additional consumption. This means that the $2 trillion lost at the low of the market would eventually imply a drop of $60-$80 billion in annual consumption (or 0.4-0.5 percent of GDP) if the market stayed at its bottom (and it didn’t). That’s not trivial, but it’s hardly a disaster even in an economy as weak as ours.

The real story of the stock plunge, then, is that it matters hugely to that small segment of the population that has substantial sums invested in the market. While less than one quarter of the population owns more than $25,000 in stock (including indirect investments though mutual funds and 401(k)s), virtually all the people involved in national economic debates fall into this category. This includes economists, reporters with major news outlets, and senior congressional staffers and their bosses. The stock market may not matter much to the economy, but it matters hugely to the people who make economic policy.

This is why the fraudulent story of the S&P stock market crash is so important. Those pushing this line know that if they can get it accepted, cutting Social Security, Medicare, and Medicaid is a done deal. While most politicians don’t want to be seen cutting these programs, they just might if they believe it would be an economic calamity if “we” didn’t step up to the plate and take the medicine. There is nothing more dangerous than a rampage of frightened policy wonks.

This means that we have to tell our stock market-addicted politicians and policy makers that it wasn’t the downgrade that sank their retirement funds. If they are concerned about their 401(k)s, they should demand stronger measures from the European Central Bank to support the euro.

Dean Baker is the co-director of the Center for Economic and Policy Research. His most recent book is False Profits: Recovering from the Bubble Economy

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posted in: economy, washington, lehman, italy, s&p, dean baker, medicare

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