Overcoming Fears of Falling Stock Prices

The stock market's historic plunge over the last year has pushed the news media into a state of near hysteria. News shows and headlines routinely roll out the scorecard on the market's new lows in the same way they might list the victims of a terrorist attack. Sad faced commentators do their best to assure us that better times lie ahead, even if they can find little reason for hope in the latest economic data.

The economic data are indeed grim, but the plunge in stock prices need not be a major cause of concern to the bulk of us who have little or no stock. The basic story is that the stock market is paper wealth, just like bonds, dollar bills or other financial assets. The strength of the economy depends on its ability to produce goods and services, not sheets of paper.

Even though the stock market has fallen by close to 50 percent, the economy still has the same capacity to produce computers and planes, to provide health care and education, and to develop new software and drugs. The economy is every bit as productive after the market collapse as it was before the collapse.

The plunge in stock prices destroyed paper wealth (lots of it). This is bad news for the relatively small group of people who had considerable stock wealth. However, for the bulk of the population, who own little or no stock, even including mutual funds in retirement accounts, the decline need not be cause for concern, since it has little direct impact on the economy.

While there is a popular myth about firms selling stock to finance new investment, in reality the stock market has rarely been an important source of investment capital. Therefore, there is little reason to expect that the plunge in stock prices will have a substantial direct impact on investment or the economy.

There can be a substantial indirect impact of the plunge on the economy. People consume based in part on their stock wealth. Close to $10 trillion of stock wealth has been destroyed in the last year. This implies a falloff in annual consumption on the order of $300 to $400 billion. Unless this demand is replaced, it will amplify the drop in consumption resulting from the collapse of the housing bubble.

But, we would be telling a similar story if the FBI had discovered and destroyed 10 trillion dollars worth of counterfeit dollar bills. This would be very bad news for the people who held the counterfeit money. The destruction of these counterfeit bills would also lead to a sharp falloff in demand. The people who had their counterfeit bills seized would suddenly be much poorer, and therefore would cut back their spending.

But the destruction of counterfeit currency need not hurt the economy, nor does the loss of stock wealth. The key part of the story is that the government must act to sustain demand. The most obvious route to sustain demand at the moment is through a large stimulus package.

Unfortunately, the Bush administration refuses to take the economy's plight seriously, but a large stimulus package will be the first agenda item of the new administration when it takes office in January. If President Obama commits the government to spending another $500 billion a year, or more if necessary, it can offset the loss in demand created by the fall in stock prices and the collapse of the housing bubble.

Of course there will be other damage created by the loss of this stock wealth. Most importantly, the plunge in stock prices has left many public and private pension funds severely under-funded. The federal government can temporarily allow for somewhat more liberal accounting standards in the case of private funds and provide limited support for state and local governments trying to keep their funds solvent. We can ensure that retirees will receive the pensions they were promised.

There will be other people who will be hit by the loss of stock wealth, including tens of millions of workers with defined contribution retirement funds. This is unfortunate and points to the problem of the defined contribution pension system. Workers are forced to bear risk to an extent they probably did not recognize and almost certainly did not want.

One of the many items on the national agenda should be the repair of the private pension system so that all workers have access to a secure form of retirement savings. The plunge in value of retirement accounts should be a painful lesson to tens of millions of hard-working people that they should never trust Wall Street or the politicians it owns.

However, the most immediate story of the market crash is that it is a redistribution of wealth that goes overwhelmingly in the direction of the less wealthy. The plunge has destroyed claims to the nation's wealth by the very wealthy in the same way that destroying $10 trillion in counterfeit bills held by mostly by the wealthy would destroy their wealth.

The key point going forward is to use government spending to ensure that demand remains strong. That way, the rest of the country need not suffer along with the formerly wealthy.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of "The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer" (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.

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