May 12, 2010 - 2:55 pm
David Whelan is a staff writer at Forbes
The American consumer is back. Spending by consumers underpins the last two quarters of positive economic output news. (5.6% growth in the fourth quarter of last year; 3.2% in the first quarter of this year.)
Why have consumers apparently stopped taking austerity measures? The most popular explanation--given that job growth and wage increases have been lackluster, and home prices still linger near lows--is what's called the wealth effect. With the stock market (measured by the S&P 500) up 23.5% last year, consumers felt confident enough to finally buy a car or a new wardrobe. (One data point: car sales were up 17% in April from the year before.)
But with the market turning significantly shakier in the last week--the wealth effect could work the other way. We asked Allen Sinai, the prominent economic forecaster, about how important the stock market is to the economic recovery.
"The role of the stock market is underappreciated," he said. And it's not just the wealth effect that ties the two together. There are four ways, Sinai said, that the stock market affects growth. If the market flags this year, so could the broader economy:
1. The wealth effect, as we mentioned
2. Cost-of-capital: Sinai says that when stocks are up, companies can raise the same amount of money by selling fewer shares, which makes it easier to fund expansion.
3. Through financial institutions: A rising market disproportionately makes business better for banks and other large financial institutions, which increases their ability to lend.
4. Taxes: A rising market allows investors to realize capital gains, which means tax revenue and even room for tax cuts.
Sinai ran a simulation for Forbes that shows how the stock market swinging one way or another would affect major economic indicators. A stock swing of 10% would increase or decrease GDP growth by 0.14%--which is significant when you consider that's $58 billion in output that could rise or fall.
A few other examples:
Consumption: A 10% stock market gain would add $78 billion in spending. But a drop would take out $60 billion.
Residential Construction: It could decline by $6.5 billion if there's a 10% correction in the stock market this year.
Realized Capital Gains: Here the effect is the largest. Gains will swing $35 billion up vs. $37.9 down, along with the stock market--explaining a lot about the volatility of these revenue streams for states like New Jersey and California.