Monday, March 14, 2016

So you believe the stock market can directly affect the economy?

Here is a link to an LA Times interview by James Peltz that features my work on link between confidence, the stock market and unemployment. Here is an excerpt. 

So you believe the stock market can directly affect the economy?
"Yes: When people lose confidence in the market and when the market stays down for three, six months at a time, people start paying attention."

Paying attention in what way?

"Imagine you're a 65-year-old couple and you have money invested in a 401(k). Now if your 401(k) drops for a week and then it comes back up again, you're probably not going to do very much. But if your 401(k) drops for three months or six months or a year, maybe you're not going to take that cruise you were going to take. Maybe you're not going to put money into your grandchild's college education.
Those decisions impact the economy. When people feel less wealthy they spend less. When they spend less, firms lay off workers and unemployment increases, and the fall in wealth becomes self-fulfilling. I believe when we feel rich we are rich."

Why is confidence so critical?

"If people are not out in the shops buying things, then firms are not going to be hiring people and one of the ways they respond is laying people off. And when people get laid off, profits fall along with demand and the drop in profits validates the original belief that their wealth was worth less. The stock market is a reflection of how wealthy we all think we are."


  1. My book "Macroeconomics Redefined" deals entirely with this. It argues that it is no accident that the Great Depression and the Great Recession both followed huge asset market crashes. The arrow of causation leads from huge falls in net worth (the median US household lost 18 years of net worth) to a compression in personal consumption expenditure to a fall in aggregate demand. In other words, unlike what Friedman's permanent income hypothesis and the Keynesian income hypothesis would have it, aggregate expenditure is not a function of aggregate demand but the other way around.

    The graph on makes this clear. It shows personal consumption expenditure falling even as personal disposable income first goes up in early 2008. Later personal disposable income follows the cue of personal expenditure.

    Personally, I am not sure economists are very good at mathematics although you wouldn't ever guess it from the complex equations you see in published papers. The graph above shows that while the average propensity to consume is close to one the marginal propensity to consume is close to zero. Therefore the Keynesian multiplier is never greater than 1. During the course of the recession proper it is even negative. But this is difficult to explain because I don't think economists understand calculus in a physical sense. To put it geekily, what matters is the partial derivative of expenditure with respect to income.

  2. On the contrary Philip. Economists spend far too much time learning calculus and other esoteric branches of pure mathematics. The typical Ph.D. economist probably knows more functional analysis than the average physicist and we cut our teeth on Kakutani's fixed point theorem. Is the value function twice continuously differentiable? Ask a graduate student in macroeconomics trying to pass her qualifying exams.

    Give me a student schooled in economic history any day!


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