Many American policymakers argue that a stockmarket collapse would inflict little damage on the real economy. Don’t bet on it

CONTRARY to some headlines at the end of last week, America’s stockmarket bubble has not burst.Yet the market turmoil has prompted one topical economic question: how much might a crash hurt America’s economy?

The answer of many American optimists is that a slump in share prices would not trigger a recession, because the real economy is fundamentally so sound. It is, they argue, much healthier than Japan’s in the late 1980s or East Asia’s economies in the mid-1990s, just before their bubbles burst. It is certainly true that America has much to boast about: a budget surplus, faster productivity growth and an underlying rate of inflation that is still historically low. Look closer, however, and the American economy is less sound than it seems.

First, although the government has moved into budget surplus, American households and firms have been on a borrowing binge. That might be fine if the debt had been used mainly to finance investments that would boost future productivity and profits. But about half of all corporate borrowing over the past two years has been used to buy back shares, which has helped to prop up the stockmarket. Meanwhile, rising share prices have made households feel wealthier and so encouraged them to borrow to finance a spending spree. Total private-sector debt in relation to GDP has risen to record levels.

This appears not to matter because share prices have risen faster than debts. But if share prices tumble households may have to cut their spending. Most worrying, margin debt (borrowing to buy shares) has almost tripled over the past three years. If share prices drop, some of this would have to be repaid immediately, forcing investors to sell shares, sending prices still lower.

A second concern is that America’s current-account deficit has risen to a record 4% of GDP. So far foreigners have been more than willing to finance that gap, attracted in part by high stockmarket returns. But America is already the world’s biggest foreign debtor, with net foreign liabilities of $1.5 trillion, around 20% of GDP. At some stage foreigners’ appetite for dollars may dry up. If this sends the dollar tumbling, it will push up inflation. America’s economy already looks red hot: retail sales jumped by 10% in the year to March, and inflation has now started to rise—to 3.7% over the same 12 months. This puts more pressure on the Fed to raise interest rates.

Conventional economic models suggest that the wealth effect by itself would slow America’s rate of growth, but that it would not push the economy into recession. However, the old rules of thumb may no longer apply. If current levels of borrowing and spending are based on the rosy assumptions of continuing high stockmarket returns, the negative impact of a crash on consumption and investment could be bigger. Heavy borrowing could turn a mild downturn into a recession if debtors suddenly had to cut spending in order to service or reduce their debts.

A crucial indicator of vulnerability is the private sector’s financial deficit (the gap between total private saving and investment), which has increased to an unprecedented 4% of GDP. Until the past few years, the private sector had been in consistent surplus for 50 years. Last year, an IMF analysis found that all economies that have previously experienced a financial deficit on this scale have suffered recessions when asset prices tumbled.

American optimists point to October 1987, when Wall Street fell by 34%, yet the economy did not dive into recession. However, there are important differences between today and 1987. First, in 1987, because the Fed eased monetary policy, share prices bounced back quickly. A sustained decline would have a much bigger impact. Many investors expect the Fed to cut rates again if the market slumps now. Yet it really needs to raise interest rates, not cut them, to curb inflation. Second, a fall in share prices would make a much bigger dent in consumer spending than in 1987, because more than half of American households now own shares, compared with only one-quarter then. And third, in 1987 the private sector was running a financial surplus, not a deficit, so it was less vulnerable to a slump in asset prices.

American policymakers hold one last trump card. They argue that previous stockmarket collapses have resulted in deep recession or even depression only because of serious subsequent policy errors that they will avoid this time. In the early 1930s, the American government and the Fed kept fiscal and monetary policies far too tight even as output slumped. Similarly, Japan’s slump in the 1990s was prolonged largely due to overly tight monetary policy and because the government was so slow to clean up the rotten banking system.

The government’s budget surplus also gives it plenty of ammunition, to cut taxes or raise spending if the economy slumps. It is worth remembering, however, that when Japan’s bubble burst in 1990, the Japanese government was running a bigger budget surplus than America today. Now it has a massive budget deficit and stock of debt. Fiscal easing can certainly stop a stockmarket crash turning into a depression, but it may not be enough to save America from some sort of recession.

LINKS

The Federal Reserve Board publishes a survey of consumer finances in the United States. It also collects statistics on the household debt burden. The Bureau of Economic Analysis and the Census Bureau also collect statistics on the American economy.

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