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Can a sinking stock market cause a recession?

When the stock market got off to a lousy start this year, some analysts fretted that the market's woes might even contribute to a U.S. economic recession in the coming months.

Such thinking generally goes against conventional wisdom, which holds that stock market trends are mainly just predictive in signaling what might lie ahead for the economy.

But UCLA economics professor Roger Farmer is among those who maintain that a prolonged slump in the market can actually help cause a recession or, conversely, help boost economic growth when stock prices enjoy a long-lasting rally.

We asked Farmer to explain his contrarian position as the market, as measured by the Standard & Poor's 500, stands nearly 3% lower so far this year after trimming its earlier losses. Here's a condensed excerpt:

The stock market is best known as a "leading indicator" of what might happen with the economy, correct?

That's correct. There's information in the stock market that helps to predict what's going to happen in the economy between three and six months later.

But you contend the market plays a bigger role in the economy's movement?

There are two ways you can think about this. One is, imagine that you watch the weather forecast every night and the forecast is usually accurate and it helps you know whether you should take your umbrella out the next day.

There's another analogy. Imagine in the middle of a drought you drop a cigarette butt in a forest and it starts a forest fire. In that view, dropping the cigarette butt is predictive, it helps you understand what's going to happen. And if you also stop people from dropping cigarette butts in forests you'll quite likely prevent forest fires.

The conventional view of the stock market is that it's like the weather forecast. My view of the stock market is that it's like the cigarette butt in the forest.

So you believe the stock market can directly affect the economy?

When people lose confidence in the market and when the market stays down for three, six months at a time, people start paying attention.

Paying attention in what way?

Imagine you're a 65-year-old couple and you have money invested in a 401(k). Now if your 401(k) drops for a week and then it comes back up again, you're probably not going to do very much. But if your 401(k) drops for three months or six months or a year, maybe you're not going to take that cruise you were going to take. Maybe you're not going to put money into your grandchild's college education.

Those decisions impact the economy. When people feel less wealthy they spend less. When they spend less, firms lay off workers and unemployment increases, and the fall in wealth becomes self-fulfilling. I believe when we feel rich we are rich.

Why is confidence so critical?

If people are not out in the shops buying things, then firms are not going to be hiring people and one of the ways they respond is laying people off. And when people get laid off, profits fall along with demand and the drop in profits validates the original belief that their wealth was worth less. The stock market is a reflection of how wealthy we all think we are.

So the loss of confidence in the stock market helped drag down the economy?

It wiped trillions of dollars off U.S. wealth. That led to a huge reduction in spending, that led firms to lay off workers and the whole thing became self-fulfilling. I still insist that the major trigger was the drop in confidence that led to the fall in the markets.

I'm saying the recession was not inevitable. There was no reason why the unemployment rate in America should have gone from 4% to 10%, which it did, in the space of a few months. Those people would have been working as happily as before, the factories and the machines they were working with were still there, the land in the United States was as productive as it was then, and yet output crashed and 6% of the labor force was laid off. That simply was not an inevitable event.

The stock market started poorly this year but has rebounded lately. What does that mean for the economy?

If the market goes back up again soon, as it did after last August, I think we'll be OK. I don't think there will be a major recession. On the other hand, if the market stays down or goes down further and stays down for a month or two months or three months, then you want to start worrying. If the market stays down and we all stay unhappy and depressed about what's going to happen, that will be self-fulfilling.

I don't think the stock market simply reflects [economic] fundamentals. Confidence in the market is itself a fundamental. The stock market is not simply a weather forecast. The stock market is a cigarette butt.

james.peltz@latimes.com

Twitter: @PeltzLATimes

Copyright © 2016, Los Angeles Times
A version of this article appeared in print on March 10, 2016, in the Business section of the Los Angeles Times with the headline "Can stocks cause recession? - UCLA professor tells why the stock market is like a cigarette butt in a forest. - ON THE RECORD" — Today's paperToday's paper | Subscribe
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