Academic journal article
By Carlstrom, Charles T.; Fuerst, Timothy S.; Ioannidou, Vasso P.
Economic Commentary (Cleveland)
When stock market values fall, we know it means investors expect lower economic growth in the future. But can stock market declines actually affect future growth? There is some evidence that they can-through the credit channel.
With the economy still officially in a recession since March 2001, all eyes are on the stock market to help answer how quickly we will rebound from the current slowdown. The reason the stock market receives such attention is that it is considered a leading indicator of future economic activity. Recessions are characterized by sharp falls in equity prices, and these typically precede slower economic growth by approximately two quarters (see figure 1). If we used the stock market as our crystal ball, albeit a very cloudy one, we would be concerned that the recession might not be over. The stock market seemed to recover during the last quarter of 2001 -by the beginning of 2002, the S&P 500 had risen
over 20 percent from its low on September 21. Since then, however, that gain has been erased, and the market is lower than it has been since 1997.
But why should stock prices and future real GDP growth be related? This Economic Commentary examines two prominent explanations for why stock market values and real GDP figures move together. The first explanation says that changes in information about the future course of real GDP may cause prices to change in the stock market today. This explanation suggests that, while stock prices are used to predict future economic activity, the actual causality is from future GDP growth (that is, the prediction of it) to current stock prices. The other explanation for the linkage between the stock market and real GDP growth is that changes in stock prices, no matter what the source, will reduce firms' asset positions and affect the cost of their borrowing. When it costs more for firms to borrow money, they borrow and invest less, and when firms invest less, real GDP growth slows. According to this view-referred to by some as balance-sheet effects and others as the credit channel stock prices will change because of changes in real economic conditions or some other factor, but the credit channel may impact the severity and length of recessions.
* Correlation Does Not Imply
Causality: Stock Prices and
While movements in stock prices precede movements in GDP, it doesn't prove that stock price movements cause changes in real GDP growth. In fact, the causality may go the other way. Stock prices reflect the fundamental value of the firm-the present discounted value of future firm earnings, so, by definition, they incorporate forecasts of future economic activity. Investors who expect future GDP growth to slow may lower stock prices today. But just as we wouldn't conclude that commuters cause afternoon rain because they decided to carry an umbrella to work after hearing the morning weather report, we can't conclude that when stock prices change today, this causes future GDP growth to change.
This implies that a fall in the stock market, if caused by some factor that does not affect economic growth directly, might not say anything about future GDP. For example, suppose that the weakness in the stock market at the beginning of 2002 was caused by general accounting worries in the aftermath of Enron's collapse and is not directly related to forecasts of future GDP growth. A fall in the stock market for this reason might be bad for your 401 (k)s but is not indicative of future low GDP growth.
There is reason to believe, however, that a decline in stock prices can have a dampening effect on real GDP growth and, in fact, cause real GDP growth to fall. The next section explains how this dampening effect works and examines the evidence for it.
* Firm Balance Sheet Effects A decline in stock prices can dampen future GDP growth through the credit channel because debt is costly. Companies raise money either by issuing additional stock or by borrowing from a bank or the public. …