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Confidence and Crashes

Summary:
The Dow dropped 4.6% on Monday February 5th.  This was the biggest recorded point drop, 1,175, in history. The markets regained some ground on Tuesday and, as of writing this post, we have simply wiped out the gains that have accumulated since the beginning of January. But we are not yet out of the woods. ...

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Confidence and Crashes

The Dow dropped 4.6% on Monday February 5th.  This was the biggest recorded point drop, 1,175, in history. The markets regained some ground on Tuesday and, as of writing this post, we have simply wiped out the gains that have accumulated since the beginning of January. But we are not yet out of the woods. If the markets continue on their precipitous decline there is real cause for concern.

The vagaries of the market are caused by the animal spirits of market participants. They have little or nothing to do with the ability of the economy to efficiently produce value. Most market participants buy and sell stocks not because they see value in the underlying companies: They buy and sell stocks because they believe that future market participants will be willing to pay more or less for the same shares. There is, after all, a sucker born every day.

But although the market does not reflect social value, it does reflect economic value. My research has shown that the ups and downs of the stock market are followed by ups and downs in employment and I have provided a theory to explain why. When we feel wealthy we are wealthy.  When we feel rich, we buy more goods and services, employment increases, and unemployment falls. There is a causal mechanism from market psychology to tangible economic outcomes.

Normally, the Fed and other central banks around the world would react to a market crash by lowering the interest rate. The cause for concern arises from the fact that they have no room to react to a market drop in the traditional manner as interest rates in the US, the UK, Europe and Japan are at historically low levels. We may be approaching a crisis of the kind I warned of in my book, Prosperity for All.  The solution, as I argue there, is for the Fed to put a floor (and a ceiling) on movements in the S&P by actively buying and selling the market.

Roger Farmer
ROGER E. A. FARMER is a Distinguished Professor of Economics at UCLA and served as Department Chair from July 2008 through December 2012. He was the Senior Houblon-Norman Fellow at the Bank of England, January-December 2013.

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