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The Stock Market and the Economy

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The Stock Market and the Economy BARRY BOSWORTH Brookings Institution The Stock Market and the Economy THE STOCKMARKET decline of 1973-74 marked the longest and steepest fall in corporate-stockprices since the depressionof the 1930s.The loss of stockholderwealth in marketprices amounted to $525 billion, or 43 per- cent.'The magnitudeof this declinein stockvalues, in conjunctionwith the subsequentcollapse of aggregatedemand in 1974-75, has sparkeda re- newed discussionof the role of the stock marketin businesscycles. The debate-as is so frequentlythe case-is not new to economics.Several sig- nificantcontributions recently made at both the conceptualand empirical levels seem, however,to justify a reexaminationof the issues. The disputeabout the import of changesin the stock marketrevolves around their causal role in economicfluctuation: Are they a source of variationin aggregatedemand? Does the causationrun solely in the op- posite direction?Or do the levels of economicactivity and of stock prices simplyrespond similarly to other,more basic, economic forces, with no di- rect causal link betweenthe two? This third interpretationis consistent with a view that the stock marketreflects investors' attempts to forecast economictrends. The fact that movementsin stock prices foretellmajor Note: I am gratefulto LeonardHerk for researchaid in writingthis article.Members of the Brookingspanel offeredvaluable comments and suggestionsin the preparationof the draft. David A. Wyss of the Federal Reserve Board staff provided the computer simulationsof the MPS model and answerednumerous questions. 1. Derived as the change between December 1972 and December 1974, as shown in Board of Governorsof the FederalReserve System, unpublisheddetail accounts, from the flow of funds (July 1975). 257 258 BrookingsPapers on EconomicActivity, 2:1975 cyclesin businessactivity is, thus, only evidencethat investors'forecasts are betterthan randomguesses. As figure 1 demonstrates,the stock marketand economicactivity do move in similarcyclical patterns.Because several previous studies have foundthat changesin the stockmarket tend to precedechanges in business conditionsby an averageof about four months,2the stock-priceindex is a majorcomponent of the indexof leadingindicators.3 The cyclicalpattern is particularlyevident in the latest recession.Stock pricespeaked at the be- ginningof 1973,then declinedsharply for two years.Industrial production, however,continued to rise throughoutmost of 1973, and its collapsedid not begin beforelate 1974. On the otherhand, as othersare quickto point out, this behaviordoes not implya causalrelation between the stockmarket and real economic ac- tivity. Furthermore,focusing only on major cycles in economic activity means ignoringthe numerousperiods when the stock market changed sharplyand nothinghappened to the economy.Saul Hymans, for example, reportsa negativeand insignificantcorrelation between lagged stock prices and an index of currenteconomic activity for the period 1948-72 in an equationthat includesother cyclicalvariables.4 Thus, it remainsunclear whetherthe collapseof the stock markethad a directrole in the 1974-75 recession,or simply mirroreddepressive developments elsewhere. In the sectionsthat follow, an effortwill be made to assessthe role of changesin stockprices in two majorcomponents of aggregatedemand: personal con- sumptionand businessfixed investment. ConsumerDemand In the vast literatureon consumerdemand, only a few studieshave fo- cuseddirectly on the influenceof changesin stock pricesand of theirasso- ciatedcapital gains and losses. In addition,those studiesthat haveexplored 2. See, for example, Geoffrey H. Moore and Julius Slhiskin,Inidicators of Business Expansionsand Contractions,Occasional Paper 103 (ColumbiaUniversity Press for the National Bureauof Economic Research, 1967), pp. 44-45. 3. For a descriptionof the currentversion of this index, see Victor Zarnowitzand CharlotteBoschan, "Cyclical Indicators:An Evaluationand New Leading Indexes," BusinessConiditionis Digest (May 1975), pp. v-xix. 4. Saul H. Hymans, "On the Use of Leading Indicatorsto PredictCyclical Turning Points,"BPEA, 2:1973, p. 346. 0~~~~~~~~~~~~~~~~~ 00 ~ C- 0 C's O..4~~~~~~~~~~. tn ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ 0 aN~ ~ ~~ ~ ~~~~~~~~~~~~~~~~~~~O 0 ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ 0 *0 0-~~~~~~.~ - .*~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~. **~~~~~~~~~~~~~~~~~~~~~~~~1 0 ~~~~~~~~~~~~~~~~~: 0Aw 0z gi .P.4~~~~~~~~~~~~~~~~~~~~~~~~~~~O ) 4k~~~~~~~~~~~~~~~~~~~~~~~~~~~~0f 260 BrookingsPapers on EconomicActivity, 2:1975 this relationshipdiffer in their emphasison two distinctmechanisms by whichthe stock marketmight affect consumer demand. The first,which is closelyidentified with the life-cyclemodel of consumerbehavior, empha- sizesthe effectof changesin wealth.The seconduses the stock marketas a proxymeasure of optimismor pessimism(so-called "consumer sentiment"). While in many applicationsthe distinctionbetween these two mecha- nismsis not important,it is centralto an evaluationof the impacton con- sumptionof changesin monetarypolicy. The demandfor corporatestock is commonlyviewed as dependentupon (1) expectationsof corporateearn- ings, and (2) the rate of returnon alternativeassets. Monetary policy can, therefore,affect the priceof corporatestock through altering rates on com- petingassets, without changing expectations of profitsor economicactivity in anyregular, predictable fashion. Thus, if the correlationbetween changes in stock pricesand consumptionfound in previousstudies reflects the role of the stock marketas a crudeproxy for consumersentiment, monetary policywould have no directcausal impact on consumption.If, on the other hand, the observedcorrelation represents a wealtheffect, an explanation for the behaviorof stock prices that includesa link to monetarypolicy becomescrucial.5 Any estimateof stock-marketeffects must rest on an evaluationof the importanceof wealthin consumerbehavior. If one acceptsthe view that consumptionreflects an attemptto maximizeintertemporal utility subject to the constraintof total availableresources, current earned income is a poor measureof that constraint.Individuals can both save for and borrow againstthe future;and they receiveincome claims from sources other than currentproduction-for example, inheritances,gifts, and capital gains. Wealth,however, is highlycollinear with permanent or normalincome; and motivesrelated to estatebuilding complicate the interpretationof the effect of wealthaccumulation on consumption.Moreover, a conceptualcompli- cationarises because the definitionof incomeused in the nationalincome accounts(NIA) alreadyreflects all earningson wealth-exclusiveof capital gains. Capitalgains on corporatestock raise other,specific, issues. Corporate- stockholdings are highlyconcentrated among the rich,and one mightwell 5. Changesin stock pricesthat result from changesin other rates may or may not be associatedwith a change in expectationsor sentiment.The significantpoint is that there may be no stable relationship,so that differentassumptions can lead to sharplydifferent conclusionsabout the impact of variationsin monetarypolicy. BarryBosworth 261 be dubiousthat unrealizedcapital gains and losses have a constrainingin- fluenceon the consumptiondecisions of such individuals.For example,in 1971,51 percentof all stock-marketassets were held by those in the top 1 percentof the incomedistribution, and 74 percentby the top 10 percent.6 In addition,capital gains and losses on suchassets are highly transitory and only a small proportionare actually realized. Data developedby Kul Bhatiaimply that realizedgains accountfor only a fifthof accruedgains.7 Moreover,the two componentsof capitalgains are not closelycorrelated. Realizedcapital gains are not includedin the NIA definitionof income althoughthey do incuran increasein taxes and thus a declinein measured disposableincome. A WEALTH VIEW OF COMMON STOCKS It is convenientto use the consumptionequation of the MIT-Pennsyl- vania-SocialScience Research Council (MPS) model of the United States as a vehiclefor examiningsome of the issues.The equation fitted to 1954-70 relatesthe quarterlyflow of real per capita consumptionservices (CON) dividedby population(N) to currentand previousvalues of disposablein- come (Y), householdnet worthexclusive of corporatestock (W - S), and an averageof recentvalues of corporate-stockholdings (S): _ (1) CON bi-) +0054 N ) + ci (N) +0.74ut-1, where bi = 0.66 ; Ec = 0.054. (12.7) Here and in subsequentequations the numbersin parenthesesare t-ratios and u is an errorterm. The sum of the coefficientson corporatestock is constrainedto equalthe coefficienton wealth,so that separatemeasures of 6. Marshall E. Blume, Jean Crockett, and Irwin Friend, "Stockownershipin the United States: Characteristicsand Trends,"Survey of CurrentBusiness, vol. 54 (Novem- ber 1974), p. 17. 7. Kul B. Bhatia, "Capital Gains and the Aggregate Consumption Function," AmericanEconomic Review, vol. 62 (December 1972), p. 869. 262 Brookings Papers on Economic Activity, 2:1975 significanceare not available;but the overall term is highly significant.8 Since the originalformulation indicated autocorrelation of the residuals, the equationis estimatedwith an autoregressivetransformation of the data. The serial correlationparameter of 0.74-the coefficienton the previous period'serror (u,)-implies that the problemis severe. This is an appealingequation as it stands.The long-runcoefficients on income and wealth are in close agreementwith earlier estimates by FrancoModigliani, Albert Ando, and RichardBrumberg.
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