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VIEWPOINTS : Unexpected Wake Will Trail Recent Market Dive

November 01, 1987|LESTER C. THUROW | LESTER C. THUROW is Gordon Y Billard Professor of Management and Economics and dean of the Sloan School of Management at Massachusetts Institute of Technology in Cambridge

The interesting question to ask about the stock market's Oct. 19 crash is not, "Why did it happen?" but "What effects will it have on the rest of the economy?" In considering this question, it is well to remember that the stock market crash of 1929 did not cause the Great Depression.

By January, 1930, the stock market had regained almost all of what it had lost back in October. What brought the economy down was the collapse of the banking system. Wisely this time, the Federal Reserve Board flooded the economy with liquidity after Oct. 19 and the banking system was never in danger.

Historically, stock markets have often fallen without anything disastrous happening to the economy.

After correcting for inflation, the stock market fell 50% between 1965 and 1982, yet the economy was more than 50% larger in 1982 than it was in 1965.

The real economic effects of the stock market are indirect. According to the latest data of the Federal Reserve Board, only 19% of the American population owns any stocks and 40% of these only own one share of stock.

As a result, falling stock prices basically only affect the wealth of the top 10% of the population.

For most Americans, any change in stock values, up or down, is irrelevant to their daily lives.

Pensions are partially dependent upon stock prices but the only stock prices that count are those that exist during my retirement.

And even here the effects are small given the way that most pensions are financed mostly out of current company earnings, current taxes or the earnings from bonds and real estate.

Effects Are Psychological

If stock prices go down, the immediate effect is on high-end luxury consumption.

Expensive Florida condominiums are difficult to sell if the stock market is falling, but with the exception of such items, few consumer purchases are really determined by stock market wealth.

The main effects are psychological. If employers or consumers become more cautious simply because they read about falling stock prices, the bottom 90% of the population may feel some effects. Consumers cut back on their purchases, employers cut back on their hiring, and earnings fall.

The likelihood of such a cutback depends upon the future course of the stock market.

Historically, stock markets tend to stage a recovery in the immediate aftermath of a crash and then enter a longer period of stagnation or further slow declines as the factors that led to the crash reassert themselves into people's decision making after they get over their initial panic and their initial gratification that it wasn't worse than it was.

But no one can predict the stock market. It is in principle unpredictable although this stops very few from trying to predict what will occur.

The simple truth is that we don't know what is going to happen to the value of stocks over the next few months.

If stocks recover quickly, the direct effects on the real economy are apt to be almost nonexistent. Even high-end luxury purchases will only be temporarily postponed.

Paradoxically, the stock market crash may even help the economy. It will do so because it scared the Federal Reserve Board into changing its policies. Prior to Oct. 19, the Fed was clearly defending the dollar with ever-higher interest rates.

After Oct. 19, it was clearly defending the stock market with lower interest rates. The lower interest rates may well in the end stimulate the economy more than the stock market crash depressed it.

A policy of protecting the stock market, however, means a policy of letting the dollar fall. The Fed can protect the dollar with higher interest rates or protect the stock market with lower interest rates, but it cannot do both simultaneously.

As a result, a lower-value dollar is probably one of the factors that will flow out of the stock market crash.

Public officials will still maintain that they are going to hold up the value of the dollar, but they have lost their main weapon--higher interest rates--for doing so.

As a consequence, no one should pay much attention to the promise of Treasury Secretary James A. Baker III not to let the dollar fall.

He is basically promising to do the impossible and when people promise the impossible, no one should take them too seriously.

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