We are seeing the usual hysteria over the sharp drop in the markets in Asia, Europe, and perhaps the U.S. (Wall Street seems to be rallying as I write.) There are a few items worth noting as we enjoy the panic.
First and most importantly, the stock market is not the economy. The stock market has fluctuations all the time that have nothing to do with the real economy. The most famous was the 1987 crash which did not correspond to any real world bad event that anyone could identify.
Even over longer periods there is no direct correlation between the stock market and GDP. In the decade of the 1970s the stock market lost more than 40 percent of its value in real terms, in the decade of the 1980s it more than doubled. GDP growth averaged 3.3 percent from 1980 to 1990 compared to 3.2 percent from 1970 to 1980.
Apart from its erratic movements, the stock market is not even in principle supposed to be a measure of economic activity. It is supposed to represent the present value of future profits. This means that if people are expecting the economy to slowdown, but also expect a big shift in income from wages to profits, then we should expect to see the market rise. So there is no sense in treating the stock market as a gauge of economic activity, it isn't.
Turning to this specific downtown, it seems clear that the troubles in China are the immediate cause. I will claim zero expertise on China's economy, but one thing seems very clear, it had a serious stock bubble. Its market rose by more than 60 percent from the start of the year to its peak in early June. At that point is was more than 150 percent above its year ago level. Even with the recent plunge, it is still more than 50 percent above the year ago level.
It was inevitable that this bubble would burst, the only question is when. The collapse undoubtedly hurt some Chinese investors, many of whom recently entered the market, often with large amounts of leverage. The direct impact on the Chinese economy is likely to be limited, these people would not in aggregate have enough wealth so that any reduction in spending would hit the economy in a big way. (Remember, people who were in the market last year are still way ahead.) There may be a political issue here for the Chinese government, which apparently encouraged people to buy into the market.
And, contrary to the children's tales about the purpose of the stock market, firms rarely finance investment through issuing shares. (The Internet bubble was an exception.) Shares are more typically issued so that early investors can cash out. So China's investment is not likely to take a hit because of the market crash.
There is a larger issue for the Chinese economy about its ability to convert from an investment and trade driven economy to one driven by consumption. This is not an easy task and it would not be surprising if China finds it difficult. I'll leave it to people who are more expert than me to give odds, but we can say a bit about the impact on this switch (or its failure) on the U.S.
From the standpoint of the U.S. economy, the main impact of a failed transition in China will be an increase in its trade surplus. A lower valued Chinese currency will mean that it exports more and imports less. Also, slower GDP growth will be a drag on its imports. Let's say that this effect raises its trade surplus by $200 billion above its baseline path, an amount equal to 10 percent of current imports.
If we assume that this increase in trade surplus is shared evenly between the U.S., Europe, and the rest of the world, this implies an increase in the U.S. trade deficit of roughly $70 billion. If we assume a multiplier on 1.5 that will reduce GDP growth over the next year by $105 billion, or a bit less than 0.6 percent.
A 0.6 percentage point hit to GDP is hardly trivial, but not the sort of thing that gives us another recession. I suppose the shift in China's trade surplus could be even larger, but it is hard to imagine it would be too much larger.
It is also worth making a point that should be obvious. This is all a story of inadequate demand. In other words, our big problem is that we are not spending enough money. I know it would be wonderful if companies went on an investment spree, but this is not likely to happen, even if a Republican president and congress give them all of our money. We may want consumers to spend more, but with savings rates at historic lows, that will not likely to happen. (People do need to save for retirement.)
This leaves trade and government spending as potential sources for increased demand. The trick to improving our trade balance is a lower valued dollar. That's a good long-term story, but hard to see much in this direction at the moment, with most other countries' economies looking weaker than ours.
That leaves the big bad government -- if we want more demand, it will have to come from the government paying for evil things like infrastructure, education, health care, and green energy. But we all know weak growth and more unemployment is the better way to go.