The American Stock Market as a Financial Risk

Overview

Developed nation policymakers will not likely have to deal with a US stock market decline that precipitates a global downturn. Most likely, guided by active, informed markets and sound government policies, the major economies will rebalance growth as needed and reprice assets gradually, making fears of an American stock market crash moot. There are, nevertheless, sound reasons for concern. The information available to markets may not be sufficient to enable them to operate efficiently, and elected leaders may be unable to implement needed reforms. It is appropriate that the Development, Trade and International Finance Working Group weigh the risks in advance.

The financial risk posed by the American stock market to the United States and the rest of the world, from our perspective, arises from negative surprises that move from the real to the financial sector. Over time the foundation for financial problems are laid when financial sector and asset price conditions diverge from the underlying real sector economic and political conditions. At some point, asset prices realign with the real sector. The realignment is a crisis if the asset price adjustment significantly increases unemployment, reduces growth, or destabilizes political processes. Generally, this occurs when some informational or liquidity shock surprises the financial sector and triggers a sudden and large price adjustment.

Such adjustments are asymmetric in the sense that the price declines occur much more rapidly than prices rose - gray-haired market participants like to observe in such cases, "Prices fall three times faster than they rise." The price movements are non-linear in that as they occur they seem to take on a life of their own, triggering within-market "herding"² and cross-market "contagion"³ that are mutually amplifying.

From our perspective, assessing whether the US stock market poses a financial risk requires identifying significant potential divergences between financial asset prices and real sector conditions and noting why financial markets may be underpricing the divergence.

We first look at a carefully modeled macroeconomic forecast of the US economy assuming a 30 percent stock market decline and note its rather benign longer-term effects under standard economic response assumptions. We then hypothesize two real sector trends that may not be fully reflected in the forecast or current US financial market conditions. We outline how there may be a real/financial sector divergence, and because of the scale of the divergence, the asset price adjustment could take on significant proportions.