Will America's Stock Market Collapse Lead to Depression?

Jeffrey D. Sachs

The billions of people in the world who don't invest in the US stock market have one big concern about America's plunging stock prices. Will the puncturing of the stock market boom incite a crumbling of the US economy, one that will spread to the rest of the world? That question is vital, because many financial bubbles have, indeed, been followed by a collapse of output and employment.

We can only guess at the answer, but my guess is that the US will escape with only a modest slowdown. My optimism may seem misplaced in a period when the stock market falls nearly every day, and when other countries have historically seen stock market collapses incite economic collapses as well.

It also seems misplaced given America's weak economic leadership. President Bush recklessly put a tax cut for the rich above all other economic concerns. He is a protectionist, not a free trader. Now both President Bush and Vice President Cheney are under scrutiny for possible corporate misdeeds while they were in business.

So why am I moderately optimistic? Examining the links between the stock market and the rest of the economy may explain this.

During a stock market boom, when share prices are bid up high by strong investor confidence, the stock market helps create an overall economic boom. Consumers who own stocks feel richer, so they buy more. These same consumers borrow money on the basis of their stock market wealth, in order to buy new homes, cars, and other expensive items.

Moreover, companies find it easy to borrow or raise new equity for capital investments, thereby creating a boom in business investments. Banks lend on easy terms to households and businesses that own high-valued stocks, believing that stock market wealth is good collateral. To secure a "piece of the action," foreign investors pour money in.

When a stock market boom ends, and prices collapse, these patterns reverse. Consumption and investment fall. Foreign investors flee. Bank loans are tightened. These factors add up to an economic slowdown. It is likely that the US will now experience some measure of slowdown, as occurred in the mild recession of the past two years.

But two forces can turn a mild slowdown into a severe recession or even depression:

stock market decline can lead to a full-fledged banking crisis, as occurred in Japan, Mexico, and most recently Argentina. Banks may find that they can't get repaid during a stock market bust. Banks may then face bankruptcy, and thus severely restrict new lending. In extreme cases, bank depositors fear for the safety of their deposits, and flee from the banks. Such depositor panic adds to the banking crisis; foreign investors may suddenly flee, as visions of easy wealth turn into financial panic. Suddenly the country is thrown into a balance of payments crisis, in which it cannot service its foreign debts. This disrupts trade and production.

My moderate optimism comes from my belief that the US will avoid both a banking crisis and a balance of payments crisis. Some American banks are likely to report large losses as a result of the stock market collapse. Yes, it is possible that the US dollar will keep losing value. But neither is likely to turn into a full-fledged crisis.

US banks still appear strong - well capitalized, reasonably well supervised, and with only moderate levels of non-performing loans. As for debts owed to foreign creditors, the good news is that America owes money to them in US dollars rather than another currency.

The US won't "run out of dollars" to service its foreign debts, in the same way that Argentina or Korea ran out of dollars needed to repay foreign creditors during the past decade. The dollar may therefore lose value as investors flee the US, but probably without provoking a more serious crisis.

Remember too that the United States can use expansionary monetary policy to offset, at least in part, any slowdown that arises. The Federal Reserve can continue to cut interest rates, if necessary. These interest rate cuts probably can't stop a slowdown from occurring, but they can help to ensure against a full economic collapse.

History's most famous stock market crash followed by an economic collapse began in 1929. America's stock market plunged in October 1929, and the US and much of the world then fell into a Great Depression. But that famous and disastrous era demonstrates the principles that I am stressing today.

The key reason for the Great Depression of the 1930s was not stock market decline, but the collapse of America's banking system that took place during 1930-33. Since there was no deposit insurance in the US at that time, bank depositors panicked when some banks began to fail. That panic incited a widespread banking failure. Moreover, the Federal Reserve did not feel free to expand the money supply at the time because the US adhered to the gold standard.

My moderate optimism should not disguise my unhappiness at America's poor economic management. The Bush Administration's reckless tax cuts and protectionist trade policies should be reversed. Corporate abuses need to be exposed and punished. But in the end, the US economy is productive and flexible and highly innovative, and is likely strong enough to withstand the irresponsible public and private economic management of recent years.