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Many folks speak about potential stock market crashes when central banks raise interest rates. I am not a graduate economist nor do I pretend to understand it, but I am definitely curious about what's happening because it affects me. I have two questions:

  1. Why is the FED/ECB/whatever raising interest rates bad for stock markets? (I am aware that this is an assumption - my information could be wrong.)

  2. Why is it so bad if the stock market crashes? If nobody wants shares of companies A,B,C or everyone is in rush to sell shares of companies A,B,C, does it mean that the companies should stop their operations? Does it mean no one would buy the goods/services produced by these companies?

In 1929 the stock market crash resulted in huge unemployment. I don't understand why. I understand why is bad for shareholders, but they are the once gambling in the first place. Everyone take these consequences as a common sense and no one really explains why is it so.

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  • $\begingroup$ Please edit the question to limit it to a specific problem with enough detail to identify an adequate answer. $\endgroup$
    – Community Bot
    Dec 18, 2021 at 18:57
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    $\begingroup$ A stock market crash is when everyone in the economy realizes the economy isn't going quite as well as they thought it was. All their promises of future income are not going to be realized. Many people react to that, quite rationally, by reducing their future expenses. $\endgroup$
    – user253751
    Dec 20, 2021 at 18:07

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Why FED/ECB/whatever raising interest rates is bad for stock markets? (I am aware that this is an assumption - my information could be wrong)

This is because interest rates critically determine price of stocks. For example, using simplistic (but for your question sufficient) Gordon stock price model, the price of stock is:

$$P = \frac{D_0}{i-g}$$

Where $D$ is dividend the stock pays, $i$ interest rate and $g$ growth rate of a dividend. As you can see increase in $i$ will decrease the stock price.

The intuition for this is that stock is nothing else, just infinite sum of discounted future dividends (which grow at some rate $g$). The higher interest rate is, the lower the present value of money that you recieve in future. For example, if I offer you \$100 in 1 year with interest rate 5%, present value of my offer is $\frac{100}{1.05} \approx 95.24$. If interest rates suddenly change to 10% suddenly the present value of the same offer (getting 100 in one year) is only $\frac{100}{1.1}\approx90.91$.

As you can see interest rate critically determines present value of future cash flows. The Gordon stock pricing model is simplistic but even in more complex models you will see the same relationship, higher interest rates mean lower stock prices - ceteris paribus.

Why is it so bad if the stock market crash? I mean if no body wants shares of companies A,B,C or everyone is in rush to sell shares of companies A,B,C, does it mean that the company should stop operation?

A) Not every stock crash has severe consequences for wider economy. For example, Black Monday (1987) was one of the largest stock crashes in history but the recession it caused was very mild (see discussion of this period in Clarson 2007 or see this Fed history blog).

B) Stock market crash can spill over to the real economy because it impedes investment. Again using simplistic, but for your question sufficient, macroeconomic model of a closed economy (See Blanchard et al Macroeconomics an European Perspective Ch 3-5):

$$Y = C +I + G$$

Where $Y$ is the output/income of the economy, $C$ consumption which we can assume to follow $C=c_0 +c_1(Y-T)$ where $c_0$ is autonomous consumption (consumption that does not depend on income), $c_1$ is marginal propensity to save (must be $0<c_1<1$ as you cannot save more that 100% of your income), $T$ are taxes and $I$ is investment and $G$ government spending (for simplicity assume balanced budget T+G$. We can show that the good market equilibrium will be given by:

$$ Y = \frac{1}{1-c_1} \left( c_0 + I + c_1 T \right)$$

As you can see if $I$ falls because investment spending falls (which could occur in the aftermath of stock market crash - when people are not willing to invest into stock which gives company money for further investments), the output/income of an economy $Y$ will fall as well.

What even more because someones spending is someone else income, there will be multiplier effect, so output might drop by more than the fall in investment itself (since $\frac{1}{1-c_1}>1$).

Does it mean no one would buy the goods/services produced by these companies?

No necessarily, as shown above, fall in investment means some people have less income, so they will spend less. The effect here is mainly indirect. It is not that fall stock market crash would make people desire to buy products less in itself, most people probably do not even know if there is stock market crash unless they hear it in the TV, but when companies invest less then someone's income is reduced and thus naturally their spending declines as well.

This being said, negative news might make people panic and decide to buy less goods and services today because they are worried about future, so there can be direct effect as well.


PS: There is of course also an extra bit of an nuance to everything above, I restricted myself to simple 101 models since you stated you are not an economist. But generally more complex models would tell very similar story.

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    $\begingroup$ If I understand these models correctly, than according to them, higher interest rates are universally bad and central banks should always set them to zero or even negative if that is possible. That's is not how reality works. A useful model should as a minimum have some variable/ condition that can influence ideal interest rate in either direction. Than you can argue that in the current situation (but not always), an increase would be bad. $\endgroup$
    – quarague
    Dec 19, 2021 at 7:21
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    $\begingroup$ @quarague These models don’t pretend to model every single aspect of the economy. According to the basic supply-demand graph, taxes are bad and have no positives. That is because the supply-demand graph doesn’t model the impacts of the government spending funded by the tax. It is still a good model. In the same way, these models correctly reflect that higher interest rates are always bad for the stock market. They do not model the positive impacts of higher interest rates elsewhere in the economy, because they are limited in scope. Remember the scope of models when drawing conclusions. $\endgroup$
    – H Huang
    Dec 19, 2021 at 10:27
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    $\begingroup$ @Hairi he does not know what he is talking about. 1. Full version of the model has monetary system in it. In my answer I use more parsimonious version, which is equivalent of using Newtonian physics for some simple problem where relativity does not matter. 2. General versions DSGE versions of IS-LM models had tremendous empirical successes (see discussion in Woodford (2012) Interest and Prices). 3. If anything the professional investors generally have terrible track record when it comes to understanding or explaining economy typically peddling discredited ideas or reinventing wheel $\endgroup$
    – 1muflon1
    Dec 20, 2021 at 11:38
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    $\begingroup$ @Hairi 1. In recent half a century economic models have a tremendous empirical successes. 2. What events you are talking about? If you talk about crises they are by nature unpredictable, that is like saying physics is just for fun because physicists can predict quantum states which are by nature random. Crises are by nature random events, if a model predicts that there is 67% chance of crisis happening on one day and crisis won’t happen that’s not failure of a model. 3. Again the same analogy you can use for physics. On small scales every particle is just a probability distribution $\endgroup$
    – 1muflon1
    Dec 20, 2021 at 12:58
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    $\begingroup$ But it’s a fallacy to say that because of that any mathematical modeling is impossible. The same hold for econ as well $\endgroup$
    – 1muflon1
    Dec 20, 2021 at 12:59
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The previous answer is amazing from economist technical viewpoint, but misses two important points of why a stock market crash is bad:

  1. "Stock market" is an abstraction. There is no "market" - there are individuals who own stocks (ultimately, even if via proxy such as a mutual fund or some other stakeholder relationship). As such, stock market crash will negatively affect many individuals, who depend on the value of those stocks for their well being.

    And before you start thinking "fatcats don't care" - don't forget that your neighbouring teacher's pension is invested in... yep you got it, stock market, not just bonds (and to make things worse, bonds that aren't inflation linked would also drop in value due to inflation itself, making the pension hit a double whammy). And that charitable foundation that pays for services XYZ for the poor... yep you guessed it, their money is largely a result of income stream of investing their endowment.

    Yes, stock market crashes on average reverse themselves eventually... but not for individual security holders, especially those needing the income short term.


  2. Similarly, a stock market crash will likely depress taxes due people's lower income... taxes that would have been used to render services to citizens. Especially non-federal taxes, since local governments can't just print money the way federal government can to raise budgets.


  3. Also, importantly, economy is a large head game. A LOT of economic activity is affected by confidence, and emotions/psychological factors in general - Homo economicus does not exist.

    Someone hears about stock crash (even if they are not invested in stocks), they are less likely to spend - multiplied by millions, that depresses the economy both short term (less spending and overall optimism) and long term (less investment, including capital expenditures with many-year-forward effect).

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    $\begingroup$ @Vikki Your question is meaningless. You'll have to define what "need" is for it to be answerable. $\endgroup$ Dec 20, 2021 at 6:44
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    $\begingroup$ @Vikki It actually is for economists (and experts in other fields). $\endgroup$ Dec 20, 2021 at 9:12
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    $\begingroup$ @Vikki The reason people sometimes put more than they can afford to lose into the stock market is that the stock market usually goes up. By investing money in shares rather than, say, paying off your mortgage, you have a high chance of making a profit (but also a small chance of losing your house). $\endgroup$ Dec 20, 2021 at 11:04
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    $\begingroup$ @Vikki The reason we don't know what money is 'needed' is that we don't know the future. Maybe I'll win the lottery. Maybe the economy will collapse and I'll lose my job and the money I have now is all that will keep me from starving. $\endgroup$ Dec 20, 2021 at 11:09
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    $\begingroup$ @Vikki, that may be your perception, but that is simply not true. Prices are constantly fluctuating, and there are booms as well as collapses. As for why the average Joe invests more than they can afford, the answer is simple: people like to gamble. When expectation (both in a layman's sense and in a probability theory sense) is positive and reality has a track record of matching expectation, people don't mind taking greater risk. The trouble comes when reality suddenly no longer matches expectation. Probabilistically, the solution is to remain invested, but people will inevitably panic sell. $\endgroup$
    – Jivan Pal
    Dec 21, 2021 at 14:52
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Your question unreservedly assumes that stock market crashes are bad. I will play devil's advocate. I can think of 3 counterarguments.

  1. Stock market crashes are good — and financially benefit — bears and short sellers — because then they profit! Particularly those who longed put options on the stocks that crashed!

  2. If the stock market crashes from a speculative bubble or irrational exuberance, then the stock market crash is completely reasonable and not the problem. The "permanently high plateau" (I am quoting Irving Fisher) or bubble was the problem, not the crash which restored and lowered stock prices to sanity, fundamental valuation and accounting values.

  3. A stock market crash can allow investors to buy and long shares of astronomically priced stocks, like FAANG and Tesla. Some brokerages lack the feature of buying fractional shares.

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    $\begingroup$ I would say that the corrective element of stock-market crashes is best accomplished by other means. $\endgroup$ Dec 20, 2021 at 9:13
  • $\begingroup$ @evolva You are right - Im not so sure it is intrinsicly bad, this is why I asked the question why is it presented as inherently bad for the general economy by mass stream thinking/media/you name it. It seems to resemble a Vegas on a larga scale that impacts all of us, but why should it be so. And there are historycal evidences that support the idea that market crash leads to unemployment and lower economic activity. Can you deny this? $\endgroup$
    – Hairi
    Dec 20, 2021 at 9:16
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    $\begingroup$ When discussing the negative impacts of being hit by a car, it is irrelevant to consider the culpability of some person irresponsbly walking into a busy avenue. $\endgroup$ Dec 20, 2021 at 16:13
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Because of feedback. At a certain point panic sets in, and prices are ho longer being set efficiently. There's just a mob screaming "sell", and no buyers.

A crash isn't of itself harmful to the real economy. It changes nothing immediate for the companies whose stock price has crashed. However, the change of perception may cause the company managements (or their bankers) to make different decisions. These may be damaging (because, panic). At this point the real economy starts to get hurt. People get laid off. People stop spending. Over-leveraged companies call in the administrators. Fear feeds on fear.

In 1987 there was a stockmarket crash that didn't seem to have any long-term effects at all. The market fell around 30% and then started rising again. It was above its pre-crash peak within a year or two, if memory serves.

1929, on the other hand ....

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  • $\begingroup$ What if one of those companies has borrowed cash and offered its own shares as collateral? $\endgroup$ Dec 21, 2021 at 14:54
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A very simple answer is that stocks are a major asset. If they are reassessed tomorrow at say, half their value, owners of those assets are now substantially poorer than they were before. This is the same as for any valuable asset: housing, automobiles, gold, bonds, bitcoin, etc. Suddenly dropping the value of assets for some people causes a great deal of unrest.

Those people suddenly reduce their spending, causing contractionary behavior in the economy. The larger the drop in asset values, the larger the contractionary behavior.

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  • $\begingroup$ The answer by @1muflon1 actually says what I have said. His language is more precise and his model gives estimates about the size of the decline under certain conditions. He's not creating illusions - he's giving a perfect answer and the one we should try to understand. $\endgroup$ Dec 22, 2021 at 18:02
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Market crashes reduce investment and demand in the economy, but in one way they are VERY important: they correct the shape of an economy that's gradually going wrong.

Businesses and consumers can gradually get into the habit of buying things that contribute less to their lives than other things that they could buy for the same money.

Here are a couple of indicators of an economy in bad shape:

  1. Persistent failure to grow

  2. Persistent trade deficit (importing more than exporting)

There aren't many economies that can stay in good shape for a long time without periodic market crashes.

"The market can stay wrong longer than you can stay solvent" - Keynes

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