Falling Stocks: The Real Economy's Achilles Heel

The stock market has always been a barometer of economic health, but recent volatility has raised concerns about its impact on the "real economy." As stocks have fallen over the past few weeks, the wealth effect—where people spend more when they feel wealthier—has been undermined, potentially leading to a reduction in consumer spending. This is particularly concerning given that consumer spending is the main engine of U.S. economic growth.

The wealth effect is about four times as big as it usually is, so falling stocks could prompt more belt-tightening than normal. This is because richer households, who have been propping up the economy with their spending, have felt flush after years of rising stock prices. However, with the recent sell-off, these households could start to tighten their belts, leading to a domino effect of reduced spending, fewer business hires, and ultimately, a potential recession.



The top 10% of earners were responsible for almost half of all consumer spending, the highest share recorded in data going back to 1989, according to an analysis by Moody's Analytics for The Wall Street Journal. This indicates that high-income households have been a major driver of consumer spending, propped up by a formerly booming stock market. However, with the recent sell-off in the stock market, these households could start to tighten their belts, leading to a domino effect of reduced spending, fewer business hires, and ultimately, a potential recession.

To mitigate the economic impact on their spending habits, high-income households can employ several strategies:

1. Diversification: High-income households can diversify their investment portfolios to include assets that are less correlated with the stock market, such as bonds, real estate, or commodities. This can help reduce the overall impact of stock market volatility on their wealth.

2. Long-term Perspective: Instead of reacting to short-term market fluctuations, high-income households can maintain a long-term perspective on their investments. Historically, the stock market has shown a tendency to recover from downturns, and holding onto investments during volatile periods can help preserve wealth in the long run.

3. Budgeting and Saving: High-income households can adjust their spending habits by creating a budget and increasing their savings rate. This can help them maintain financial stability during periods of market volatility and ensure that they have sufficient funds to cover their expenses.

4. Income Generation: High-income households can explore opportunities to generate additional income, such as through part-time work, consulting, or rental income. This can help offset any reduction in investment returns and maintain their spending habits.

5. Professional Advice: High-income households can seek the advice of financial advisors who can provide personalized strategies to navigate market volatility and protect their wealth. Financial advisors can help households make informed decisions about their investments and develop a plan to mitigate the impact of falling stock prices on their spending habits.

In summary, falling stock prices can significantly affect the confidence of high-income households, leading to reduced spending and potential economic repercussions. However, by employing strategies such as diversification, maintaining a long-term perspective, budgeting, generating additional income, and seeking professional advice, high-income households can mitigate the economic impact on their spending habits and preserve their wealth.



The recent events surrounding the global financial crisis and its aftermath have brought into sharp focus the relationships between financial markets and the real economy. One such linkage concerns the performance of equity markets and the impact on unemployment rates. Expectations of future economic conditions have an important influence on the stock market, and hence market returns have long been recognized as a reliable predictor of the business cycle. Numerous studies have found that the stock market is an indicator of future economic activity, and an increase in stock market returns is indicative of a decline in the unemployment rate. For example, the work of Phelps, 1994, Phelps, 1999, Hoon and Phelps (1992) and Phelps and Zoega (2001) explain the connection between the stock market and unemployment rate using a range of arguments that draw on expectations of future profits and the impact on employment.

The recent events surrounding the global financial and debt crises and fall in stock market valuation have been accompanied by an increase in the unemployment rate whereas a number of economic and financial downturns prior to this have not caused such a large decline. In assessing this linkage, little is understood about the impact of stock market volatility on the unemployment rate, or about asymmetries in terms of the impacts from positive and negative stock market shocks. In an attempt at addressing these shortcomings in the existing literature, our investigation offers new insights into the relationship between the stock market and unemployment rate. Using a GARCH-in-mean VAR procedure advocated by Elder and Serletis (2010) applied to US data over the study period 1948–2014, we show that the unemployment rate is adversely affected by stock market volatility. Further to this, we also find that positive and negative stock market shocks have asymmetric short-run impacts on the unemployment rate. We also briefly reflect on what policy prescriptions can be drawn from these empirical results.

The literature suggests that expectations of future economic conditions exert an important influence on asset valuation, and thus stock market returns should forecast changes in economic activity. For example, Phelps (1999) and Hoon and Phelps (1992) explain the connection between the stock market and unemployment rate using the Phelps (1994) structuralist model of the natural rate of unemployment. In Phelps' model, expectations of future profits cause firms to invest in customer relationships.