What the Stock Market Slump Might Mean for the Economy and Politics

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About the author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

As the stock market rout intensifies, there is good news and bad news for President Biden. The good news is that the stock market is not the economy. The bad news is that the stock market’s recent slump can negatively impact the economy and with it the Democratic Party’s chances in November’s midterm elections.

The Federal Reserve has shifted toward a more hawkish monetary policy stance in the first few months of this year. The results have been nothing but brutal for the stock market. In April, the tech-heavy Nasdaq index fell by more than 13%, marking its worst month since October 2008. Meanwhile, since the start of the year, the more representative S&P 500 index has lost some 16% in value, wiping out almost all of last year’s gains.

During his term in office, President Trump never tired of citing the stock market boom as conclusive evidence of the economy’s strength. He did so even though output and employment growth under his presidency was not materially different from that under President Obama.

Trump also did so even though the stock market’s performance has more to do with the Federal Reserve than with the administration’s economic policies. When the Fed floods the markets with liquidity by printing money and keeps interest rates very low, the stock market tends to boom. When the Fed turns off the monetary policy spigot and raises interest rates, the stock market tends to swoon.

The stock market is also not nearly as good an indication of the nation’s prosperity as is the growth in output and employment. To be sure, while the stock market now constitutes around a record 40% of the nation’s wealth, that wealth is in the hands of a relatively small minority. CNBC estimates that the wealthiest 10% of the population own almost 90% of the stock market’s wealth. Meanwhile, 44% of the population is reported as not owning any stocks at all.

While the stock market is not the economy, it certainly can have an impact on economic performance. This is especially the case as at present when the stock market swoons abruptly and when it wipes out value amounting to some 33% of GDP.

A market rout like this can undermine consumer confidence. When households lose money in the market, they feel less wealthy than they did before. That induces them to want to save more and spend less.

According to Federal Reserve estimates from 2003, for every dollar that households lose in wealth on a sustained basis, they tend to cut spending by around 4 cents. This means that if the recent stock market decline is sustained, consumer spending could be reduced by around 1.25% of GDP. This could be sufficient to tip the economy into recession, coming as it does on top of an expected decline in consumption as a result of higher energy and food prices as well as a cooling in the housing market on account of sharply higher mortgage rates.

The stock market’s decline can also make it more difficult for companies to raise new capital. That in turn can cause companies to scale back their investment spending for want of adequate financing.

All of this bodes poorly for the Democrats’ prospects in November, especially considering the Fed’s proposed course of action to tame the inflation beast. It is not simply that the Fed is planning on a series of additional 50 basis point interest rate increases. Rather it is that beginning in August, the Fed is proposing to drain $95 billion in liquidity from the markets by not rolling over its maturing bond holdings.

In much the same way as the stock market was buoyed in 2021 by the Fed adding $120 billion a month in market liquidity through its bond purchases, so too might the Fed constitute a drag on the stock market when it begins to drain liquidity on a large scale.

Biden might be justified in wanting to assign at least some of the blame for any future recession to Fed Chair Jerome Powell. The Fed allowed the stock market party to go on for too long in 2021. But this argument is unlikely to cut much ice with the voters. It is Biden’s Democratic Party, and not Powell, who is up for election.

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