Stock markets plunged worldwide last week (although some like India's have bounced back this week). Many were quick to pronounce that the underlying problems at financial institutions were grave enough to undermine economic growth.
I must beg to disagree. Stock market declines do not necessarily translate into setbacks for economies. Depends. Various factors are relevant: the soundness of banks, the policy response to a a stock market crash, companies dependence on stock market for finance for projects (pretty low in the US- nearly 98% of funds come from internal generation and the debt market and in some recent years, funding from stock market has been negative because of buybacks of stocks) and the wealth effect on consumption (also low in the US and lower still in markets such as India).
The killer is bank exposure to the stock market. Once banks fail, the economy is dragged down quickly. That's what happened in the Great Crash of 1929. It also happened in East Asia. The worst sufferer was Indonesia where the IMF mandated closure of bankrupt banks caused the a huge fall in GDP.
In India, the RBI's prudence has been a great life-saver. Stringent restrictions on bank exposure to stock markets (and also real estate) are one big reason why the vagaries of the stock market have not meant banks going under (except when banks, especially cooperative banks, sought to flout regulations).
In the present situation, many financial institutions have been hit by the problems in the subprime mortgages market but not commercial banks. Institutions have been trying to sell their holdings of securities linked to such mortgages and have otherwise taken huge hits. The liquidity problems at hedge funds and investment banks spells dog days for international financial markets. But commercial banks are relatively unsinged, so the US economy will not face a crisis. The world economy is not affected by US-specific factors and hence global economic growth will continue to be strong.
I have more comments in my ET column , Market, not economic, crisis.
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I agree that the declines in the stock market do not (necessarily) mean that the economy is going south ... but it does send a signal ... In the US, the subprime woes have been somewhat exaggerated ... true, many mortgage companies have (and will fail) and banks will take a hit ... but many parts of the country remains strong and are weathering the storm
On the issue of 1929/Depression, it is interesting that for several months after the October 1929 crash, the market actually edged up slowly ... there were many reasons for the depression - the Smoot Hawley act imposing restrictions on trade and tariffs on imports to the US were a primary cause for the onset and worsening of the economic conditions (according to the Wall Street Journal)
The 1987 crash was significantly worse than the 1929 crash - yet after some hiccups, the economy started growing again ... Greenspan, at the Federal Reserve helm, did all the right things (so it seems) - With the Democrats controlling the US Congress, there is a lot of talk from Charlie Rangel and Chuck Shumer on trade restrictions and tarrifs to deal with the "deficits" ... So, I worry that Smoot Hawley may be raised from the dead ...
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