On October 19, 1987, stock prices took their biggest-ever one-day plunge. The Standard and Poor’s index of 500 stocks dropped 20% that day, after having fallen by 16% from the market’s peak in August of the same year. About $1 trillion of financial wealth was eliminated by the decline in stock prices on that single day.
Stock prices in the United States soared during the 1990s, especially during the second half of the decade, but then tumbled sharply early in the first year of the new century. Stock prices continued to fall for several years, and stockholders lost wealth of about $5 trillion, an amount equal to about half of a year’s GDP.
After rising from 2003 to 2007, stock prices plunged during the financial crisis of 2008, with stocks losing 48% of their value in real terms. By the first quarter of 2009, real stock prices were at their lowest level since 1995.
What are the macroeconomic effects of such booms and busts in stock prices?
We have emphasized two major macroeconomic channels for stock prices: a wealth effect on consumption and an effect on capital investment through Tobin’s q.
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Let’s see how each of those effects worked after the stock market crash of 1987, the increase in stock values in the 1990s, the decline in stock market wealth in the early 2000s, and the financial crisis of 2008.
The wealth effect on consumption arises because stocks are a component of households’ financial assets. Because a stock market boom makes households bet-ter off financially, they should respond by consuming more; and likewise, a bust in the stock market reduces household wealth and should reduce consumption.
To show how consumption and stock prices are related, Figure 4.11 plots the value of the S&P 500 index, adjusted for inflation, along with the ratio of consumption spending to GDP.
Consumption and the 1987 Crash
We would expect that following the 1987 stock market crash, consumers would reduce spending, but the decline in consumption should have been much smaller than the $1 trillion decline in wealth, because consumers would spread the effects of their losses over a long period of time by reducing planned future consumption as well as current consumption. If consumers spread changes in their wealth over 25 years, then we might guess that current consumption spend-ing would decline by about $40 billion (assumspend-ing the real interest rate is near zero). However, consumers might also worry that the stock market crash would lead to a recession, so they might cut consumption further; such a scenario suggests that consumption should decline by more than $40 billion. However, economists who estimated the actual decline in consumption suggest that it FIgure 4.11
real u.S. stock prices and the ratio of consumption to gDP, 1987–2012 The graph shows the values of the real (inflation-adjusted) S&P 500, which covers a broad cross-section of U.S. cor-porations, and the ratio of consumption spending to GDP from 1987 to the first quarter of 2012. The variables move together in some episodes and in opposite directions in other episodes.
Source: S&P 500 from Yahoo finance Web site, finance.
yahoo. com; real S&P 500 calcu-lated as S&P 500 divided by GDP deflator; GDP deflator, consumption spending, and GDP from St. Louis Fed Web site at research.stlouisfed.org/
fred2 series GDPDEF, PCEC, and GDP, respectively.
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Year
Ratio of consumption to GDP
Real S&P 500 (left scale) Ratio of consumption to GDP (right scale)
(continued) MyEconLabReal-time data
142 Part 2 | Long-Run Economic Performance
fell less than $40 billion.16 Why did consumption decline less than economic theory suggests? Perhaps the reason is that the rise in stock prices had been very recent—stock prices had risen 39% in the 8 months preceding the crash. Because the increase in stock prices occurred so rapidly, it is possible that by August 1987, stockholders had not yet fully adjusted their consumption to reflect the higher level of wealth. Thus, when the market fell, consumption did not have to decline by very much to fall back into line with wealth.17
Consumption and the rise in Stock market Wealth in the 1990s
The U.S. stock market enjoyed tremendous growth during the 1990s. The S&P 500 index more than tripled in real terms by the end of the decade. Our theory pre-dicts that such gains in stock market wealth should be associated with increased consumption spending.
However, contrary to our theory that an increase in wealth should increase consumption, consumption does not appear to have been closely correlated with stock prices in the 1990s. Research by Jonathan Parker of Northwestern University shows that there has been a long-run increase in the ratio of consumption to GDP that began in 1979.18 He concludes that no more than one-fifth of the increase in the ratio of consumption to GDP in the 1980s and 1990s resulted from increased wealth associated with the stock market boom. And in Fig. 4.11, we can see that stock prices increased significantly from 1995 to 1998, yet consumption declined relative to GDP in that period.
Consumption and the Decline in Stock Prices in the early 2000s
Following the peak of the stock market in early 2000, stock prices declined for three years, erasing about $5 trillion in wealth. Our theory suggests that consumers should respond by reducing their consumption spending. Yet Fig. 4.11 shows that, in fact, consumption spending increased significantly relative to GDP during that period, rising from 67% of GDP in 1999 to 70% in 2002. Several reasons may explain why consumption did not decline after stock prices fell: (1) the reduction in people’s wealth is spread throughout their lifetimes, so there is not a large immediate impact on consumption; (2) at the same time stock prices declined, home prices rose, so many people who lost wealth in the stock market gained it back in real estate; and (3) people may have just viewed their gains in the late 1990s as “paper profits” that were lost in the early 2000s, so neither the gains nor the losses affected consumption.
Investment and the Declines in the Stock market in the 2000s
As we have seen in Fig. 4.11, the stock market fell precipitously in 2000 and 2008.
The large declines in the stock market led to large declines in Tobin’s q, the ratio of
16See C. Alan Garner, “Has the Stock Market Crash Reduced Consumer Spending?” Economic Review, Federal Reserve Bank of Kansas City, April 1988, pp. 3–6, and David Runkle, “Why No Crunch from the Crash?” Quarterly Review, Federal Reserve Bank of Minneapolis, Winter 1988, pp. 2–7.
17In “Consumption, Aggregate Wealth, and Expected Stock Returns,” Journal of Finance, June 2001, pp. 815–849, Martin Lettau and Sydney Ludvigson noted that, prior to the crash, aggregate consump-tion was unusually low relative to stock market wealth. Their analysis indicates that this behavior reflected consumers’ expectations of a decline in the stock market.
18”Spendthrift in America? On Two Decades of Decline in the U.S. Saving Rate,” in B. Bernanke and J. Rotemberg, eds., NBER Macroeconomics Annual, 1999, Cambridge: MIT Press, 1999.
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the market value of firms to the replacement cost of their capital, as you can see in Figure 4.7 in “In Touch with Data and Research: Investment and the Stock Market,”
p. 134. This figure also shows very sharp declines in real investment beginning shortly after the stock market and Tobin’s q began to fall in 2000 and again in 2008.
The slight delay in the fall in investment, relative to the fall in the stock market, reflects the lags in the process of making investment decisions, planning capital formation, and implementing the plans. But despite these lags, the declines in investment following large declines in the stock market are quite evident.
the Financial Crisis of 2008
During the financial crisis of 2008, stock prices plunged rapidly. In the six months from August 2008 to February 2009, U.S. stock prices declined in nominal terms by 43%, one of the fastest declines in stock prices on record. Investors feared that a depression was possible because of a meltdown in the financial sector, which had taken excessive risks, especially in real-estate markets. The recession that had begun in December 2007 became much worse, and the unemployment rate increased dramatically. In this case, unlike the episode in the early 2000s, home prices also declined, and the simultaneous decline in housing prices and stock values translated into a nearly 20% decline in household net wealth, which fell from $62.6 trillion at the end of 2007 to $50.4 trillion by the end of March 2009. Yet the ratio of consumption to GDP declined by less than 1 percentage point in 2008, as Fig. 4.11 shows, and then it rebounded in early 2009.