Plunging Global Stock Markets Do Not Show the Dependence of the World Economy on the Fed

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Friday, 21 June 2013 05:11

Suppose the price of corn plummets. Does that mean that the world economy is going down the tubes?

Well, it could be the result of the collapse of demand in the world economy leading to less demand for all commodities or it may just be the result of a bumper corn crop. The latter would be good news for the world economy even though it would be bad news for farmers who produce lots of corn.

Such is the case with stock markets. Stock markets move up and down all the time often for reasons that have nothing to do with the state of the economy. They also have very little predictive power. The market has more than doubled from its 2010 lows even though growth has averaged a pathetic 2.0 percent over the last three years. 

Their effect on the economy is also limited. Few companies rely on the stock market to raise capital for investment. The main impact of the stock market on the economy is through the wealth effect on consumption. This is usually estimated as being in the range of 3-4 percent. That means a 10 percent run-up in the stock market, which would generate roughly $2 trillion in wealth, would eventually lead to $60-$80 billion in additional annual consumption. (The impact is usually estimated to be felt over a 2-3 year period.) With a multiplier of 1.5 this implies an impact of 0.6-0.7 percentage points of GDP. That is not trivial, but it is hardly the difference between a booming economy and stagnation.

This is why the NYT badly misled readers with a lead sentence in an article that said:

"Tumbling stock, bond and commodity prices around the world are demonstrating just how reliant the global economy has become on the monetary policies of the Federal Reserve."

The movements in markets showed that the markets respond to actions of the Fed. The plunge in stock prices is bad news if you own a lot of stock, just as a plunge in corn prices is bad news if you have lots of corn. It is not necessarily bad news for the economy.