Harvard economist Robert Barro’s article in the Wall Street Journal about the relationship between stock market crashes and depressions is just … plain … weird.
The bottom line is that there is ample reason to worry about slipping into a depression. There is a roughly one-in-five chance that U.S. GDP and consumption will fall by 10% or more, something not seen since the early 1930s.
Our research classifies just two such U.S. events since 1870: the Great Depression from 1929 to 1933, with a macroeconomic decline by 25%, and the post-World War I years from 1917 to 1921, with a fall by 16%. We also assembled long-term data on GDP, consumption and stock-market returns for 33 other countries, sometimes going back as far as 1870. Our conjecture was that depressions would be closely connected to stock-market crashes (at least in the sense that a crash would signal a substantially increased chance of a depression).
This idea seems to conflict with the oft-repeated 1966 quip from Paul Samuelson that “The stock market has predicted nine of the last five recessions.” The line is clever, but it unfairly denigrates the predictive power of stock markets. In fact, knowing that a stock-market crash has occurred sharply raises the odds of depression. And, in reverse, knowing that there is no stock-market crash makes a depression less likely.
There’s nothing wrong with Barro’s research per se. It’s just strangely simplistic and incurious, particularly by the standards of a top-notch economist at a top-notch institution. What the paper does (it will cost you $5 to download and read it) is essentially to take a census of (i) stock market crashes and (ii) severe economic downturns in industrialized economies from the late 19th century onward. It finds, unsurprisingly, that the one thing tends to be found more frequently in the presence of the other.
And that’s really all it does. It doesn’t address what order the events occur in: stock market crashes that somewhat lag depressions are treated the same by Barro as those which lead them. Nor does it purport to address the really meaningful and interesting questions, which are as follows:
Does the stock market contain information is not well reflected by other economic indicators? That is, can you make a better prediction about the fate of the economy by knowing the trajectory of the stock market than you can with other readily available economic indicators?
If so, does a stock market crash merely predict a depression? Or is it actually a contributing cause toward a depression?
Without answering these questions, the paper isn’t a whole lot more insightful than one telling you that beachballs are found more often in the presence of sand, and vice versa. Do beachballs predict sand? That is a matter of semantics, I suppose. But do beachballs tell you anything useful about sand? Not really.
Actually, I’m not being fair to Barro and his co-author José F. Ursúa. There is a very interesting and worthwhile part of the paper about the relationship between stock market crashes and the equity premium.
But this is not the part that’s being reproduced in the Journal. Rather, the Journal is engaged in an ongoing project to use the stock market as proxy for the performance of the economy as a whole, and by extension, the performance of the Obama administration. (It is certainly not alone in this regard; tune on CNBC or browse the archives for other examples.) This article tends to cement in the public’s head the relationship between the stock market and the economy, and therefore must have been appealing to the Journal.
Obviously in the long run, there is going to be some reasonably strong relationship between the stock market and the economy. But the stock market can also deviate significantly and over long periods of time from economic fundamentals. It’s a pretty rough indicator — empirically much less useful than other metrics like money supply, manufacturing output and interest rate spreads in predicting the economy’s fate.
And if there’s anything that should have taught us that, it’s been the past dozen or so years. The failure of markets to price assets efficiently is arguably one of the principal causes of the current economic crisis. I am increasingly wondering whether blind faith the rationality of asset markets might tend to perpetuate it.