STU 04-02 : Special Topic - Stock market prices and economic growth [ Short Term Update 04-02 - 29/11/2002]

Triggered by the bursting of the technology bubble, eq-uity prices in the three most advanced economies have been on an almost continuous downward trend since peaking in March 2000 . After a brief recovery in the autumn of 2001, stock market prices have again fallen precipitately in the last few months. The recent collapse in equity prices is different in the sense that it is now widespread and is not mainly con-centrated in the ITC sector. It reflects partly a loss of credibility of audited accounts, as a result of a number of accounting scandals in the United States. Between the end of March and the end of October 2002 the Dow Jones EURO STOXX 50 and the US Standard & Poors’ 500 dropped by 33% and 23% respectively.

The most thoroughly described and empirically tested channel between equity prices and economic activity in the economic literature is the so-called wealth effect on private consumption. The theory of permanent income tells us that, in addition to anticipated future income, an upward shift in financial and non-financial wealth which is perceived as permanent will induce consumers to spend more of their current income. Based on this mechanism, the impact of a shift in equity prices on consumption will depend on two factors: the level of house-hold equity holdings and the propensity to consume out of equity wealth.

Concerning the first factor, while US households’ direct and indirect equity holdings, as a percentage of total financial assets, remained almost unchanged at around 30% between 1997 and 2000, in the euro area this share increased from 15% to 20% during the same period. This higher stock market exposure implies that, in comparison with a few years ago, a given fall in equity prices will mean a larger decrease in the financial wealth of households in the euro area.

Concerning the second factor, most empirical studies find that in the United States there is a significantly higher marginal propensity to consume out of equity wealth (between 0.03 and 0.05) than in most individual euro area countries (estimated at around 0.01). The explanation put forward is twofold. Firstly, in so-called market-based economies like the US, consumers are less credit-constrained in the sense that they have access to a wider range of credit instruments, which means that it is easier for households to borrow against their assets than in bank-based economies. Secondly, the higher propensity to consume out of wealth in the United States may also be due to the fact that a greater proportion of households have direct equity holdings as compared with the euro area.

Stock market prices can also impact consumption through a second channel. According to the dividend discount model, equity prices should reflect expected future dividends. Similarly, a decline in equity prices could be interpreted by households as an increased downward risk in relation to prospects for economic growth and employment. This may, in turn, harm consumer confidence and lead to an increase in the savings ratio, even if households do not possess equity holdings. A few empirical studies have found some evidence of a (weak) equity price effect on consumer confidence in the United States but no such relationship could be established for euro area countries.

Stock prices can also have a direct impact on business investment, mainly through two channels. The first channel operates via the cost of equity capital. A decrease in equity prices means that the market value of the firm relative to the replacement cost of its stock of capital (called Tobin’s q in the literature) declines. As the cost of financing investment through new issues of equities increases, the firm will lower its investment spend-ing as some projects previously perceived as profitable will be cancelled. Capital stock will gradually adjust to the lower long-term level and q will return to its normal value. The second channel operates through the balance sheet effect. Decreasing equity prices erode corporate collateral and reduce the firm’s ability to borrow and consequently to invest. The link between stock market prices and investment should be stronger in countries where firms rely more on equity funding (as in the United States), but investment also should not be immune to equity price movements in bank-based economies because in these countries financial institutions own large equity holdings and there can be substantial effects on their balance sheets. Nevertheless, only a relatively weak empirical relationship between stock price movement and business investment has hitherto been found for euro area countries.

According to the European Commission, the recent decrease in equity prices “...is somewhat atypical and could be associated with a stronger drop of investment than during previous stock market corrections”. In a ‘normal’ situation, the downward revision of expected future earnings would be associated with reduced borrowing interest rates, reflecting lower growth prospects and lower inflation. But, as has already been mentioned, the current collapse is partly due to a loss of confidence in company balance sheets and it could, in this case, have contributed to a rising risk premium and reduced access to corporate loans, as reflected by increasing spreads on lower-grade corporate bonds since April of this year both in the United States and in Europe.

To summarize, there are good reasons to believe that the recent fall in equity prices will have a negative effect on consumption and investment, particularly now that stock market corrections have hit all the major economies simultaneously, which should reinforce the synchronization in business cycle movements.