How does the stock market affect the economy?

There is a saying: stock markets have predicted 10 out of the last 3 recessions.

With plummeting share prices making headline news, it is worth considering the impact of the stock market on the economy. How much should we worry when share prices fall? How does it impact on the average consumer? and how does it affect the economy?

Economic Effects of the Stock Market

1. Wealth Effect

The first impact is that people with shares will see a fall in their wealth. If the fall is significant it will affect their financial outlook. If they are losing money on shares they will be more hesitant to spend money; this can contribute to a fall in consumer spending. However, the effect should not be given too much importance. Often people who buy shares are prepared to lose money; their spending patterns are usually independent of share prices, especially for short term losses.

2. Effect on Pensions

Anybody with a private pension or investment trust will be affected by the stock market, at least indirectly. Pension funds invest a significant part of their funds on the stock market. Therefore, if there is a serious fall in share prices, it reduces the value of pension funds. This means that future pension payouts will be lower. If share prices fall too much, pension funds can struggle to meet their promises. The important thing is the long term movements in the share prices. If share prices fall for a long time then it will definitely affect pension funds and future payouts.

3. Confidence

Often share price movements are reflections of what is happening in the economy. E.g. recent falls are based on fears of a US recession and global slowdown. However, the stock market itself can affect consumer confidence. Bad headlines of falling share prices are another factor which discourage people from spending. On its own it may not have much effect, but combined with falling house prices, share prices can be a discouraging factor.

4. Investment

Falling share prices can hamper firms ability to raise finance on the stock market. Firms who are expanding and wish to borrow often do so by issuing more shares – it provides a low cost way of borrowing more money. However, with falling share prices it becomes much more difficult.

As I said earlier there is an oft repeated quote saying the stock market has predicted 10 out of the last 3 recessions. The point is that falling stock markets do not necessarily predict the economic future. Share prices can fall without causing a downturn in the economy. For example, one thinks of the stock market crashes of October 1987; there wasn’t an obvious economic factor causing this share price fall. The major economies remained relatively unaffected by this stock market crash. In fact, the UK had record growth in the late 1980s. This time the stock market fall is due to economic weaknesses so is a better guide to future economic performance.

5. Bond Market

A fall in the stock market makes other investments more attractive. People may move out of shares and into government bonds or gold. These investments offer a better return in times of uncertainty. Though sometimes the stock market could be falling over concerns in government bond markets (e.g. Euro fiscal crisis)

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