What do stock market fluctuations mean for the economy? – Brookings Institution

This Article Was Originally From This Site

Stock market prices as measured by the S&P 500 reached an all-time peak on January 26. Less than two weeks after the peak, stock prices plunged more than 10 percent, erasing about $2.6 trillion of wealth. For purposes of comparison, the drop in stock market values represented a bit less than one-seventh of last year’s GDP. It is natural to wonder about the impact of such a large wealth loss on the economy.

As many analysts have pointed out, the effects of such a drop are ordinarily small. First, stock market prices fluctuate widely, usually with very limited impacts on the investment and consumption behavior of most Americans. Indeed, by the close of trading at the end of last week, stock prices had rebounded nearly 6 percent from their recent low, offsetting more than half the loss suffered in the market correction. As of last Friday, the S&P 500 index was actually above its level at the start of the year. Since the current economic recovery began in 2009, the stock market has experienced five corrections in which equity prices fell at least 10 percent. Few consumers or investors can afford to revise their plans whenever stock prices rise or fall 10 percent.

A second reason that stock fluctuations have limited direct effects is that stocks are not an important form of saving for most households. According to a recent Gallup poll, only 55 percent of Americans say they or members of their household own stocks. Other surveys find even lower participation rates in the stock market. If you do not own any equities, there is little reason to change your spending, saving, or work plans because Wall Street suffers a major reverse. Gallup polls suggest stock ownership shrank over the past decade. Just before the Great Recession, 65 percent of Americans said they owned stocks. Evidently, the twin stock market crashes in 2000-2002 and 2008 reduced some savers’ appetite for risk.

Among the households that do own equities, stock ownership is highly concentrated. NYU’s Edward Wolff estimates that the wealthiest one-tenth of households own more than 80 percent of stocks. Of course, the wealthiest one-tenth of households also accounts for an outsize share of total consumption. While stock market fluctuations probably have a negligible impact on the consumption of small shareholders and households that do not own any stocks, there can be noticeable effects of a stock downturn if wealthy shareholders reduce their spending. One estimate suggests that a sustained drop in stock prices that subtracts $100 from household wealth will eventually reduce annual consumer spending by $2 or $3.

One of the crucial links between average households and the stock market is through workers’ retirement plans. A majority of full-time, prime-age workers is offered coverage under an employer retirement plan. The pension promises of these plans are largely backed by stock market investments. In the case of workers enrolled in 401(k)-type plans, workers themselves select the investments that will eventually fund their retirements. People in these plans typically place a big slice of their retirement savings in equities. In traditional, defined-benefit retirement plans, the employer chooses the investments. In these plans, too, over half of the funds are invested in equities.

There is an important distinction between old-fashioned pensions and newer 401(k)-type plans. In a traditional plan, the employer bears the ultimate responsibility of paying for promised pensions. That responsibility remains, even if the plan’s investment strategy produces lousy returns. Workers enrolled in a traditional plan do not bear the risks of stock ownership, because they are assured of receiving their pensions regardless of stock market performance. In contrast, workers in 401(k) plans and those who hold their savings in IRAs bear the full risk if their investments perform badly. When the stock market tanks, 401(k) and IRA savers who invest in equities face the prospect of a less prosperous retirement. This shouldn’t cause much anxiety among workers in their 30s or 40s who are decades away from retirement. But it ought to be a major concern for workers near retirement or already retired. Many of these workers have large retirement account balances, and a big share of their balances is invested in equities.

When the stock market tanks, 401(k) and IRA savers who invest in equities face the prospect of a less prosperous retirement.

When thinking about the effects of the stock market on the economy, it is worth considering two important trends. First, the private retirement system provides a steadily rising percentage of all retirement payouts. The private system consists of private and public employer pension plans plus IRAs. Back in 1990, the private system made annual distributions to beneficiaries that were about 8 percent less than the payouts from the public retirement system–Social Security and Supplemental Security Income. By 2015, the annual distributions from the private retirement system were 57 greater than the payouts from the public retirement system. The retirement system that is backed largely by stock market investments has thus grown over time.

Second, workplace retirement plans have shifted away from traditional pensions toward plans in which workers directly bear the financial risk of poor investment performance. In 1990, $2 out of every $3 paid out by the private retirement system consisted of payouts from traditional defined-benefit plans. Just $1 out of every $3 represented a distribution from 401(k)-type plans or IRAs. By 2015 more than half of all private retirement payouts came from 401(k)-style plans or IRAs. Not only has the retirement system shifted away from unfunded public programs and toward asset-backed pensions, the asset-backed plans have increasingly shifted toward plans in which workers and retirees, rather than employers, shoulder the financial risk of lousy returns.

In the new system there is an obvious channel through which stock market gyrations can affect behavior. When equity prices soar, workers in 401(k) plans become richer and may be able to retire at a younger age. When the stock market slumps, people in these plans are poorer. They have to work longer to enjoy a comfortable retirement.

Economists have tried to measure the effect of stock market fluctuations on retirement patterns, but generally find very small effects. One reason, as we have seen, is that many people do not own stocks or have very small holdings. Another may be that it is very hard to distinguish the impact of stock market fluctuations separately from the effects of other economic factors that help determine stock prices. The biggest changes in stock prices often occur immediately before or at the same time as recessions, when investors think company profits are about to fall. At that point any impact of stock market prices on retirement is likely to be dwarfed by the impact of rising layoffs and low hiring rates. Workers with a shrunken stock portfolio might wish to work longer, but there are fewer employers willing to keep or put them on a payroll.

The gradual shift of the nation’s retirement system toward asset-backed pensions and 401(k)-style workplace plans may mean that retirement patterns become more sensitive to stock prices. So far, however, that channel of effect seems comparatively modest.

This Article Was Originally From *This Site*