With stock market prices hitting new highs despite interest rate- and money supply headwinds, this is a timely opportunity to explore how a stock market sell-off may trigger a GDP recession ("recession").
A recession may come about in many ways. But since GDP (nominal and real) is largely a reflection of the level of debt-inflated consumer spending, changes in the supply of money and consumers' time preferences (i.e. the spending vs. saving decision) always play major roles. These two are also capable of bringing about a stock market correction since broad-based increases in stock prices over time are driven by monetary inflation and a reduced demand for money to hold (i.e. decreased demand for cash balances). Our focus here will however be on how a stock market sell-off may trigger a recession.
First and foremost, crashing stock prices affect economic developments as they so utterly destroy the shaky foundation an elastic money supply and fractional reserve banking to a large extent are built on; confidence. In his book about the great depression Chester Phillips writes (p. 161),
The stock market crash provided the shock to confidence which definitely and dramatically started the depression on its downward course, revealing to most persons for the first time the inherent instability of the conditions which had prevailed for several years.
In this sense, falling stock prices can act as recession or depression triggers. That is however all they are: it is not actually falling stock prices that cause the recession, but rather the factors that brought about the preceding bull market. This sheds light on why surging stock prices over time is a leading recession indicator. A stock certificate trading on the stock exchange (or anywhere else) is not itself wealth. Rather, it is a claim on the wealth (expected to be) generated by the company it represents. Therefore, changes in the market price of a stock merely represent a change in the valuations of an already existing asset.
This explains why for example the US. Bureau of Economic Analysis (BEA) excludes capital gains from income and saving computations. In BEA's own words,
Capital gains represent changes in the price of already-existing assets, but only an expansion of the real stock of assets via investment represents an increase in the wealth of a society.
A stock certificate and the price it can be bought and sold for in the secondary market is therefore the price paid or received for a claim on wealth, and not real wealth in itself. Furthermore, trading shares is a way of distributing and re-distributing the claim on the wealth created or destroyed by a company over time - increasing or decreasing stock market prices therefore only serve to re-distribute claims on real wealth.
Changing valuations of a stock hence merely decides the financial distribution of this claim on wealth between the sellers and buyers of certificates according to their subjective valuations. Some gain while others lose, but on the net it is a zero sum game with no real effect on the economy's overall wealth. Which brings us to an important point: since wealth for an economy is not generated from increased stock prices, no wealth is destroyed by falling ones. As Fritz Machlup notes (p. 289),
Losses by stock-market speculators constitute no real capital losses to society.
The same holds for all contractual claims on (future) wealth that are exposed to capital gains and losses (e.g. bonds, derivatives, house prices). In the financial markets, wealth is never created nor destroyed by increases and decreases in prices; claims on wealth is instead simply redistributed whenever the market prices- or ownership of these claims changes hands.
In this regard, it should be pointed out that stocks are appraised according to some expected future, i.e. it is based on expectations and the valuations they generate. Real wealth however doesn't exist sometime in the future. It is something that actually exists today and which has already been built, created, or made. The real value (or lack thereof) is created by the company through the profits it actually generates, and the capital it accumulates. The appraisal of these results does not in itself create wealth however. If it did, stock market participants could simply agree to swap stocks at prices above current market values making all better off economically in the process. The reason they don't make such ludicrous exchanges however is of course that it makes no economic sense whatsoever since it would make no one better off (actually, it would make them worse off due to transaction costs). A similar reasoning can be applied to other assets as well, for example real estate. A general increase in the prices of existing houses does not represent increased wealth to society. Again, if it was that simple to create wealth we could all simply agree to swap houses at above market prices and be better off as a result.
It is though important to acknowledge that the secondary market serves an important function in attracting and allocating capital in an efficient manner, and steering savings toward investments with the best prospects. This must not be confused however with real wealth creation. Capital markets are facilitators and distributors, but not creators, of wealth. The second part of Phillips' above quote is therefore the more important one; a stock market crash reveals to everybody what was previously unknown to most, namely that the economy had actually been heading in the wrong direction for some time. This revelation makes market participants act more in line with reality, which usually entails a slowdown in spending and an increase in saving. For some time, until the market has adjusted and settled into the new economic circumstances and a new money relation is established, economic activity drops and major economic aggregates measured in monetary terms such as GDP fall unless offset by government or central bank interventions. Real production also will likely take a hit as inventories are sold into falling consumer demand. If the market is left alone, all these effects will be transitory.
Secondly, and sometimes directly linked to a lack of confidence, a stock market sell-off may trigger a decline in bank lending as uncertainty spreads and banks' focus shift toward protecting their reserves. Increased uncertainty may also induce consumers to spend less and save more. When these two events happen, deflationary pressures set in. A negative feedback loop may then develop; increased uncertainty brings about less lending and spending, which brings about more uncertainty and further declines in lending and spending, and so forth. Whether this process is ended quickly, or proceeds rapidly or slowly, depends on a range of factors, including (preemptive) actions taken by the FOMC.
At the time of writing, the more likely scenario appears to be that declines in bank lending- and money supply growth will first bring about a stock market sell-off rather than the other way round. Following on from the article issued last week, the y/y growth rate in bank lending dropped again on Friday, from 4.6% to 4.3%....
...driven by a further steep decline in the expansion rate of Commercial & Industrial lending...
...pulling the money supply growth rate down with it.
This time around, further drops in bank lending growth might therefore precede a stock market sell-off. Having said that, a stock market correction would, as it usually does, speed up the process and make the recession arrive sooner. Of perhaps greater significance, a larger stock market correction would quickly destroy the illusion of prosperity the $6.1 trillion increase and near doubling of the money supply since the eve of the banking crisis in September 2008 has helped create. That is perhaps when we will see the true extent of the economic imbalances that by now have built up in the U.S. economy. In light of this and with stock market prices fetching record valuations, the U.S. economy is arguably more fragile at this point in time than many may realise.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.