The stock market reflects the economy, it does not cause it

Photo by Markus Spiske on Unsplash

Prominent economist Robert Samuelson once quipped that “the stock market has forecast nine of the last five recessions.” I love this quote because it elucidates something economists understand but is poorly understood outside academic circles: the stock market is not the economy.

As a society, we put too much stock (no pun intended) in the various fluctuations of the investment markets. The most recent example of this is an article in The New York Times whose headline screamed “Investors Have Nowhere to Hide as Stocks, Bonds and Commodities All Tumble.” Again, the question is raised whether fluctuations in the financial markets will cause a recession. But in reality, markets don’t cause recessions.

Take the classic example of the Great Depression. My students, and my wife for that matter, were convinced that the depression was set off by the stock market crash in October 29, 1929. In reality, when you look at the financial indicators, the United States was already in full recession by the summer of 1929. The stock market crash simply reflected that fact, and it did little to make things worse. What did make things worse was a series of bank failures starting in November 1930 that brought the nation’s financial system to the brink of collapse.

This recession started as part of the regular business cycle, something that was inevitable back in this time in which money was based upon a gold standard. Where now we have a fiat currency, where the value of our dollar is based upon the overall economic power of the United States, back then each dollar was backed by a certain amount of gold the nation had in its reserves. The benefit of this policy is that the value of the dollar fluctuated very little. The disadvantages, however, were many. For example, since the value of the dollar was based upon the price of gold rather than the strength of our economy, the dollar could be strong while the economy was in crisis, or vice versa. Also, the fact that the supply of money was relatively fixed, the economy would go up and down like a yo-yo. The good times were almost evenly balanced by times of recession. Long periods of growth with short periods of recession, like our economy experiences now, were impossible back then. The money supply simply couldn’t grow fast enough to support it.

Focusing on the money supply here is important since, in general, economists have come to agree that this is the most important factor impacting our economy. This hypothesis was originally advanced in 1963 by famed economists Milton Friedman and Anna Schwartz in their weighty piece of scholarship, A Monetary History of the United States. In that book, the authors reviewed the history of American economic performance dating back to the period just after the Civil War and found that periods of growth and recession were explained very well by the amount of money in circulation in the economy. In effect, the more money in circulation, the better the economy was doing.

Former Federal Reserve Chairman Ben Bernanke was a scholar of the Great Depression who had actually written papers based upon the research of Friedman and Schwartz. He fully accepted their argument that the quantity of money in the economy is related to economic performance. Thus his response to the Great Recession, which was to aggressively push money back into the economy even as other factors reduced its availability.

One might ask why, then, the government doesn’t just print more money to goose up the economy? There are three answers to this question. First is that the government does do that at times. A prime example would be the recent tax cut and subsequent deficit spending by the Trump administration. In effect, they have pushed more money into the economy and consequently, the economy has boomed, even despite the fact that we were already at full employment. Another example of this phenomenon occurred when Nixon increased the money supply just prior to his re-election campaign in 1972. Such political machinations, by the way, are part of the reason that a Federal Reserve Board independent of political influence is so critical.

The second answer to this question involves the consequences of increasing the money supply too quickly. The result of such efforts is inflation, and runaway inflation has been caused when politicians, trying to improve their standing, rapidly increase the money supply. Zimbabwe under Robert Mugabe simply started printing money to pay its bills. The result was hyperinflation of 500,000,000,000%, according to the International Monetary Fund. Not wanting to go there is part of the reason responsible governments don’t simply print more money.

The final answer involves how money is created in our country. In the United States, money does not come from the government, or even the Federal Reserve. Money is created privately in our financial system. Let me explain.

When somebody deposits $1 into a bank, that bank lends it out to someone else. At the time, the depositor has $1 in their bank account and the borrower just got $1 lent to them. Thus, $1 turned into $2.

Then, the borrower deposits their $1 into their bank. The borrower’s bank then lends that $1 out to someone else entirely, creating another $1 just as above. Thus $1 turned into $3 with no involvement from the government. This process goes on arithmetically pursuant to something we call the money multiplier.

So you can see that when banks pull back on their lending, as they do when they perceive problems with the ability of their borrowers to pay back loans when an economic crisis hits, money becomes more difficult to come by, thus hurting economic performance. Suddenly, there is less money for business investment, less money for wages, and we find ourselves in a full-blown recession.

A classic example of this phenomenon was the 2008 Great Recession. The Great Depression actually had three runs on the banks that each reduced the money supply. In response, the federal government established the FDIC to stop such financial panics, and this policy has been largely successful. The problem is that by 2007, a separate banking system had emerged, sometimes called the shadow banking system. This system involved more money than our well regulated banking system, and it was made up of hedge funds and other complicated investment vehicles. What happened in 2008 is that there was a run on this banking system in response to fears over the long-term value of mortgage-backed securities. This run, like the historic bank runs pre-FDIC, took money out of our economy and precipitated a serious recession. Fortunately, Ben Bernanke, having studied Friedman and Schwartz and the Great Depression, moved as quickly as possible to shore up our money supply and thus reduce the severity of the recession. He was largely successful in that effort.

Investors in the stock markets and the bond markets and the commodities markets have very little impact upon the economy, then. Instead, they are trying to anticipate a coming financial crisis and move their money to safer investments whenever they perceive one to be coming. That is why we pay attention to the stock market. These investors have a lot more time and expertise to be looking at the financial indicators than most of us do. As a result, when we look at the fluctuations of the stock market, we are picking the brains of these expert economic analysts as to what they think is going to happen with the economy.

The U.S. economy, and certainly the world economy at this point, are extremely complex and driven by millions of factors simultaneously. As a result, even the analysis by the most experienced stock expert is still a guess based upon incomplete information. That is why, as Samuelson pointed out, they so often get it wrong.

By the same token, it is important for the rest of us not to prioritize the machinations of the stock market above what it deserves. I do think, as apparently do most investors, that a recession is coming and soon. But that recession won’t be caused by a crash in the stock market. It will be caused by economic fundamentals that prompt banks to reduce their lending and thus decrease the money supply. The only remaining question will be how long and how severe the contraction is. That is yet to be seen.

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Mike is an Assistant Professor of Management for Legal and Ethical Studies at Oakland U. Mike combines his scholarship with practical experience in politics.

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