August 31, 2015
Dean Baker
Al Jazeera America, August 31, 2015
View article at original source.
One of the benefits of the massive inequality in the distribution of wealth is that the vast majority of us can sit back and enjoy the show when stock markets go into a worldwide panic, as they have been doing for the last couple of weeks. In spite of what you hear in the media, fluctuations in the stock market generally have little direct or indirect impact on the economy.
This means that if you don’t have a lot of money in the stock market, you don’t have much to lose. And, according to data from the Federal Reserve Board, three quarters of households have less than $36,000 in the stock market, including their 401(k)s.
But the markets have been putting on quite a show, so it is worth asking what is going on. At the most basic level, it seems evident that China’s market had a very serious bubble. Its main index had increased by more than 150 percent from June of 2014 to its peak in June of this year. While it’s possible that China’s market has hugely undervalued in 2014, it seems more likely that this rise was bubble-driven. This means that people were buying into the market because they saw it going up, not because they had done an assessment of the future profit prospects for Chinese companies and decided that they were worth two-and-half times as much as they had been worth a year earlier.
Bubbles inevitably burst. At some point there are no longer people willing to pay too much for stock, houses, tulips, or whatever. That seems to have been the story in China, where many new investors were buying into the market on credit. At some point they have trouble borrowing further and the upward spiral goes into reverse. The clumsy efforts of China’s government to stop this correction proved largely futile.
The next question is why did the fun spill over to Europe, the United States, and the rest of the world’s stock markets? Most of these markets are high by historic standards, but they are not obviously experiencing bubbles. To use one common metric, Robert Shiller’s ratio of the S&P 500 to trailing ten years’ earnings peaked at just over 26 to 1 in June. This is higher than the long term average of 15 to 1, but well below the peak of 44 to 1 in the late 1990s bubble. There would be a similar story with most other major markets.
Furthermore, in the late 1990s there was an obvious investment alternative. Ten-year U.S. Treasury bonds paid a nominal interest rate of over 5.0 percent which translated into roughly a 2.5 percent real rate at the time. Currently 10-year Treasury bonds are paying a bit over 2.0 percent interest, which translates into a real interest rate of roughly 0.5 percent. Given these fundamentals, there is no reason to expect sharp declines in the U.S. and other major markets, but nothing says that they can’t be 5–10 percent below current levels.
But there are some stories for the real economy that do go along with the stock market turbulence. First, China is going through a process of adjustment where it goes from growth led by investment and exports to growth led by domestic consumption. The stock market run-up was helping this transition as people increased their consumption based on bubble-generated wealth. The plunge in prices will hurt this process, but it is important to remember that stock prices are still almost double their level of last summer.
While predictions of a collapse of the Chinese economy will almost certainly be proven wrong, it is likely to be on a slower growth path going forward. This is a major factor in the falloff in commodity prices, most notably oil, the price of which has dropped below $40 a barrel. This drop in oil prices will exacerbate the economic troubles of major oil exporters like Russia and Venezuela.
However, the drop in commodity prices could have even more far-reaching effects. The economies of Canada and Australia have also been driven to an important extent by booming commodity exports. These economies recovered much more rapidly from the 2008 crash than most other wealthy countries. Part of this story is that that house prices in both countries quickly returned to bubble levels.
The price of a typical home in Canada is 13 percent higher than in the United States despite the fact that its per capita income is more than 20 percent lower. In Australia, with an average income that is 93 percent of the U.S. level, the median house price is almost twice the U.S. level. It’s pretty hard to tell a story where this gap is justified by the fundamentals of the market. After all, neither country is notably short of land (not that this explanation generally makes sense).
It may turn out to be the case that the plunge in commodity prices will be the factor that will teach homebuyers and potential homebuyers in these countries the arithmetic they need to recognize the bubbles in their markets. If that proves to be the case, then we may see the unraveling of these bubbles, and that will not be a pretty picture.
Unlike stock, middle income people do have a real stake in the value of their house. If prices in these countries were to fall to U.S. levels, it would imply a massive loss of wealth. This will almost certainly lead to a large drop in consumption and in all probability a serious recession.
That is not a good story, but perhaps one day we will get people in policy positions who take bubbles seriously. After all, the only way to prevent serious damage from a housing bubble like the ones these countries are now experiencing, or the one the United States experienced in the last decade, is to keep it from happening in the first place.
