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U.S. House Prices Analysis and Trend Forecast 2019 to 2021

Will a Plunging Stock Market Send the Economy Into Recession?

Economics / Austrailia Jan 21, 2008 - 04:44 PM GMT

By: Gerard_Jackson

Economics So far this month the Australian share market has dropped by 10 per cent, sending some people into a panic and raising the spectre of recession. Let us begin by putting this in historical perspective. In October 1987 the Australian share market plunged by 50 per cent. This drove the economic commentariat to wail that the economy was heading into a deep recession.

As we all know, there was no recession. The commentariat had fallen prey to the old fallacy of post hoc ergo propter hoc. This came about because of the myth that the October crash of 1929 sank the US economy and brought on the Great Depression. It did nothing of the kind. The US economy was contracting months before the market crashed.

In short, share market fluctuations ? no matter how extreme ? cannot cause recessions. I am not denying that there is a link between the two phenomena, only that it is not a causal one. For instance, MFS (Managed Investment Funds Australia) shares dropped by over 75 per cent. Market observers based this precipitous fall on concern about the company's debt position.

The point is that the economy is loaded with debt that fuelled the housing boom, the current account deposit and the share market. And the source of this debt? The illustrious Reserve Bank of Australia. There is nothing new in this observation. Fritz Machlup (a member of the Austrian school of economics) stressed that a stock market boom requires a continuous flow of bank credit. In other words, credit expansion. Therefore a

... continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply. (Fritz Machlup The Stock Market, Credit and Capital Formation , William Hodge and Company Limited, 1940, p. 290).

Hence many of the things we are now witnessing are merely symptoms of an extraordinary credit expansion, the inevitable result of which will be another "recession we had to have". So when will the recession strike? To answer this question let us once again refer to Machlup

. . . monetary factors cause the [business] cycle but real phenomena constitute it, Essays on Hayek, Routledge, Kegan Paul 1977, p. 23).

In the case of the crashes of 1929 and 1987 real factors were completely ignored, as was the case with the last American recession. Back in 1999 I warned that the US economy was moving into recession. I emphasised the fact that manufacturing was contracting and shedding labour, a sure sign that recession had started. In addition, I also stressed that commentators would be deceived by the unemployment rate because it would continue to fall. This is because the demand for labour at the stages of production near the point of consumption would for a time be sufficient to offset job losses in manufacturing.

In other words, real factors signalled a recession even as consumer confidence, share prices and the aggregated job figures were signalling a continuing boom. According to the statistics December 20,000 jobs were created, making a total of 260,000 for 2007. What is important about these figures is that they appear to be pretty evenly spread out, meaning that manufacturing is not shedding labour. This was confirmed by the latest Pricewaterhouse-Coopers PMI (performance manufacturing index) which reports various labour shortages emerging in the manufacturing sectors.

The current demand for labour has ? as expected ? brought forth the old fallacy that when labour markets get tight wages become inflationary which then forces the central bank to raise interest rates. That it was inflation ? a loose monetary policy ? that increased the demand for labour is never considered. That is why these commentators never bother to examine the Reserve's money supply figures.

If they did so they would find that for November 2006 to November 2007 M1 rose by 13 per cent. The figure for M1 from March 1996 to November 2007 is even more damning, coming in at an unprecedented 117 per cent while the growth in bank deposits rose by 147 per cent. It ought to be clear to our economic pundits that credit expansion is the driving force behind Australia's boom. Nevertheless, they will still insist that wages growth is the real inflationary danger.

So while they focus on the wages' phantom the PMI tells us that the country has had 19 consecutive month of growth and that capacity utilisation was 77.14 in December 2007 compared with 75.2 for December 2006, even though the same period saw the export index drop from 60.4 to 50.9.

What this amounts to is that despite severe disequilibrium (disproportionalities would be a better term) in the economy real factors have not yet moved far enough to bring on recession. However, that does not mean that the Reserve will not halt the boom by slapping on the monetary brakes. Either way, a recession is unavoidable.

By Gerard Jackson

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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