A collapse in U.S. stock prices certainly would cause a lot of white knuckles on Wall Street. But what effect would it have on the broader U.S. economy? If Wall Street crashes, does Main Street follow? Not necessarily. Consider three famous episodes: the U.S. stock market crash of 1929, Japan's crash of 1990-1991, and the U.S. crash of 1987.
The 1929 U.S. crash and the sharp decline in Japanese stock prices were both followed by decade-long economic slumps in each country. (The Japanese depression, despite much whistling in the dark by the country's policymakers, still lingers.) By contrast, the macroeconomic fallout from the 1987 tumble on Wall Street was minimal. Why the difference?
A closer look reveals that the economic repercussions of a stock market crash depend less on the severity of the crash itself than on the response of economic policymakers, particularly central bankers. After the 1929 crash, the Federal Reserve mistakenly focused its policies on preserving the gold value of the dollar rather than on stabilizing the domestic economy. By raising interest rates to protect the dollar, policymakers contributed to soaring unemployment and severe price deflation. The U.S. central bank only compounded its mistake by failing to counter the collapse of the country's banking system in the early 1930s; bank failures both intensified the monetary squeeze (since bank deposits were liquidated) and sparked a credit crunch that hurt consumers and small firms in particular. Without these policy blunders by the Federal Reserve, there is little reason to believe that the 1929 crash would have been followed by more than a moderate dip in U.S. economic activity.
The downturn following the collapse of Japan's so-called bubble economy of the 1980s was not as severe as the Great Depression. However, in some crucial aspects, Japan in the 1990s was a slow-motion replay of the U.S. experience 60 years earlier. After effectively precipitating the crash in stock and real estate prices through sharp increases in interest rates (in much the same way that the Fed triggered the crash of 1929), the Bank of Japan seemed in no hurry to ease monetary policy and did not cut rates significantly until 1994. As a result, prices in Japan have fallen about 1 percent annually since 1992. And much like U.S. officials during the 1930s, Japanese policymakers were unconscionably slow in tackling the severe banking crisis that impaired the economy's ability to function normally.
Central bankers got it right in the United States in 1987 when they avoided deflationary pressures as well as serious trouble in the banking system. In the days immediately following the October 19th crash, Federal Reserve Chairman Alan Greenspan -- in office a mere two months -- focused his efforts on maintaining financial stability. For instance, he persuaded banks to extend credit to struggling brokerage houses, thus ensuring that the stock exchanges and futures markets would continue operating normally. (U.S. banks, which unlike their Japanese counterparts do not own stock, were never in any serious danger from the crash.) Subsequently, the Fed's attention shifted from financial to macroeconomic stability, with the central bank cutting interest rates to offset any deflationary effects of declining stock prices. Reassured by policymakers' determination to protect the economy, the markets calmed and economic growth resumed with barely a blip.
There's no denying that a collapse in stock prices today would pose serious macroeconomic challenges for the United States. Consumer spending would slow, and the U.S. economy would become less of a magnet for foreign investors. Economic growth, which in any case has recently been at unsustainable levels, would decline somewhat. History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.