SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 29)

The Stock Market (part A)

by

Charles Lamson

Buy low, sell high!!

Speculative Bubbles and Their Effects on the Economy

In the past, a book on the financial system and the economy would not routinely include a chapter on the stock market, nor would it include a chapter on the bond and mortgage markets. Such chapters would more likely be found in a text dealing specifically with capital market assets. Texts on the financial system traditionally focused on the banking system. So why does this book The Financial System & the Economy include such chapters?

At this time, there are compelling reasons to include chapters on the stock, bond and mortgage markets---reasons that relate to the recent price volatility of these assets and the changing structure of capital markets. Most of us are familiar with the record stock market boom of the late 1990s. Stock prices underwent dramatic increases despite some sharp sell-offs. Technological changes in how funds are transferred, increased globalization of financial markets, and other structural changes in the economy have facilitated the flow of funds into equity investments around the world.

At the same time, more households than ever were investing in the stock market, whether directly through a broker, their employer, or online, or indirectly through a savings or retirement plan.

When stock price movements are more pronounced, stock markets have a greater potential for speculative bubbles that cannot be sustained. A speculative bubble is an irrational increase in prices accompanied by euphoric expectations. When market participants realize that the speculative bubble cannot be maintained, they tend to liquidate their positions with the result that prices fall to lower levels than if the bubble had not occurred in the first place. Such volatility in stock prices can cause financial instability as gains and losses are magnified. When the bubble bursts, the resulting financial losses spill over into the real sector, causing unemployment and recession.

The Fed attempts to minimize fluctuations in output and prices around a long-term trend. At that time we were concerned about output prices of goods and services. The Fed must also be concerned about unstable stock prices. Volatile stock prices can affect employment, inflation, and the health and stability of the financial system. If a speculative bubble bursts and stock prices tumble, the real sector can be adversely affected for a considerable time. The Economist magazine aptly states: "Just as champagne tastes wonderful until the bubbles go to your head, so financial bubbles tend to create nasty economic hangovers."

The stock market rally of the late 1990s was interrupted briefly by a worldwide collapse of stock prices in October 1998. By early 1999, the market had fully recovered and was reaching new highs. An economic downturn began in early 2001 and was exacerbated by the attack on the World Trade Center and the Pentagon on September 11, 2001.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 377-378*

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