Reprinted from America AlJazeera
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. Despite 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 the most recent data from the Federal Reserve Board, three quarters of U.S. households had less than $36,000 in the stock market, including their 401(k)s, in 2013.
But the markets have been putting on quite a show, so it's worth asking what is going on. At a basic level, it seems evident that China's market had a very serious bubble. Its main index increased by more than 150 percent from June 2014 to its peak this June. While it's possible that China's market was hugely under-valued 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 appears to have been the story in China, where many new investors bought 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: 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 calculation of the ratio of the price of the S&P 500 stock to corporate earnings hit a high of just over 27 to 1 in June. This is higher than the long-term average of 17 to 1, but well below the peak of 44 to 1 in the late 1990s bubble. Most other major markets have a similar story.
Furthermore, in the late 1990s there was an obvious investment alternative. Ten-year U.S. Treasury bonds paid a nominal interest rate of more than 5 percent, which translated into roughly a 2.5 percent real rate at the time. Currently 10-year Treasury bonds are paying just over 2 percent interest (or, a real interest rate of roughly 0.5 percent). Without a more appealing investment alternative, there is no reason to expect sharp declines in the U.S. and other major markets, though they could dip 5 to 10 percent below current levels.
But there are some real economic stories that do go along with the stock market turbulence. First, China is going through a transition from growth led by investment and exports to growth led by domestic consumption. The stock market run-up helped this transition as people increased their consumption based on bubble-generated wealth. The plunge in prices will hurt this process, but note 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 that of oil, 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.
The drop in commodity prices could have further-reaching effects. The economies of Canada and Australia have 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, in part because 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 U.S., 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. Market fundamentals don't explain this gap; it's hard to believe that people in Canada and Australia value housing so much that they are willing to pay a much larger share of their income for it.
If the plunge in commodity prices alerts potential homebuyers to the bubbles in their markets, 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 houses. 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 such as 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.
