SYNOPSIS: How to keep a Panic from becoming a Recession
Investors buy because others are buying, sell because others are selling. When stock prices are rising, it's called "momentum investing"; when they are falling, it's called "panic." And panic, which had been building all week, broke out in full on Friday.
One of the biggest losers in the final sell-off was Tiffany's: the price of the jeweler's shares abruptly fell 13 percent, apparently because investors feared that it was especially vulnerable to a market decline. And they may well be right. ("He's your guy/ when stocks are high,/ but beware when they start to descend./ It's then that those louses/ go back to their spouses./ Diamonds are a girl's best friend.") But will the turmoil in the stock markets spill over, not just into jewelry, but into the real economy generally? Is this the end of the "Goldilocks economy"?
It's happened before. Never mind 1929 -- that stock slump occurred in an environment of institutional weakness and sheer policy stupidity that I think (I hope) no longer exists. We aren't going to raise interest rates to peg the dollar to gold, or allow banks to tumble like dominoes. The example to worry about is Japan in the 90's -- an economic juggernaut that stumbled badly after the burst of a financial bubble, and even a decade later has by no means regained its former vigor.
And indeed, some Japanese have been arguing for years that any day now the United States is going to go through the same comeuppance they experienced -- that our "new economy" is as fragile, perhaps illusory, as their bubble economy of the late 1980's. And after the last week a few Americans may be wondering if they have a point.
But I've been obsessed with Japan's economic problems for years -- it really bothered me to see a wealthy, politically stable country seemingly unable to pull itself out of a simple demand-side slump. I think I have some idea why in their case what started as a mere paper loss ramified into something much worse. And to me America's prospects of avoiding a similar fate look very good.
Broadly speaking, there are three ways that a stock slump can turn into a prolonged recession. First, a decline in stock prices can expose an underlying lack of good projects for businesses to invest in. Second, falling prices of assets can undermine corporate balance sheets, leaving companies unable to make investments no matter how justified. Third, a financial slump can inspire perverse government actions -- like raising interest rates to defend your exchange rate even as the real economy implodes.
On the first count: America is in the midst of a technological revolution -- unlike Japan, which in 1990 was at the end, not the beginning, of a productivity surge. And demography is on our side: a steadily growing work force, thanks in part to immigration, should help to sustain continuing high investment.
On the second count, things could be much worse. There has been some increase in corporate debt in recent years -- and some individuals have, of course, gotten overextended. But we don't need yet more dot-coms to keep the economy going, and by and large the prospect that companies other than dot-coms will find themselves unable to pursue profitable investment projects because they are unable to raise the cash seems remote.
On the final count: Sometimes it's good to be big. The United States has a huge economy, which despite growing international trade is not all that dependent on imports. So even if the new nervousness on Wall Street drives down the value of the dollar -- certainly a possibility --- the Federal Reserve won't feel that it has to raise interest rates to prop up our currency. Nor need we fear, the way smaller Asian countries did in 1997-98, that we will be crushed by the burden of foreign-currency debts: we do have debts to foreigners, but relative to the size of our economy they aren't that large -- and anyway (shhh! don't tell anyone) they're in dollars.
So the best bet has to be that our real economy will come through this nervous period more or less unscathed; it's been ugly in the markets, but it isn't the end of the world; Goldilocks is still alive and well. And anyone who has been selling on the belief that it is the end of the world ought to take a deep breath and calm down.
Originally published in The New York Times, 4.16.00