MOUNT VERNON — Wall Street began to recover Wednesday after Dow Jones industrials took a 416-point dive on Tuesday.
William Melick, Gensemer associate professor of economics at Kenyon College, gave his impressions on Tuesday’s stock selloff and what precipitated it. To understand what happened Tuesday on Wall Street, he said it’s important to bear in mind what investors consider when they are pricing shares of stock.
“They are, of course, looking for future earnings,” Melick said. “The fundamental thing to realize is that everyone is thinking, ‘I think that stock will pay me some stream of dividends based on earnings in the future. In order to assign value to that equity, I have to somehow translate those future dollars into how valuable they are to me today.”
Melick said even a small change in people’s perception of risk can lead to a big change in how they value that stock price.
“If my perceptions of the risk associated with any future payments go up, today’s value of those future payments is going to fall and it can fall quite dramatically,” he said.
A number of factors converged to lead to the stock market selloff on Tuesday, Melick said. Stock markets in China did poorly. Chinese investors were afraid that China was going to put some restrictions on how easy it would be to purchase shares of stock. In particular, the fear was that the country would change an investor’s ability to buy stock on margins — that is, the ability to borrow money to buy stocks.
At the same time, he added, the U.S. economy appeared to be growing more slowly than expected. Concerns about a sluggish housing market in the U.S. added to investors’ fears.
“The financial system does a lot of mortgage lending,” Melick said. “If home prices are not growing or are falling in many areas, concerns about financial institutions that made loans for mortgages begin to rise.”
He said it now seems clear these concerns led investors to revise the risk of future payments they might receive if they own shares of stock, which led to a sudden change in the current price for those stocks.
“If consumers are getting nervous as well, then the first place that nervousness will be felt is in the durable goods market,” Melick said. People might put off buying a new car or a new washing machine if they become nervous about the future of the economy. They might put off that purchase, he said, and a drop in durable goods orders can serve to rattle investors.
“If durable goods orders are falling, then you’re thinking maybe people are a little uncertain about the future, and, therefore that makes any claim on the future less valuable,” he said.
A stock market plunge in China has what is best characterized as an indirect effect on Wall Street, Melick said.
“It’s not a direct connection in the sense that if share prices in China fall it has to be true that share prices in the U.S. fall,” he said.
Melick said China produces a lot of goods for export; the U.S. purchases a lot of those goods. China runs what is called a current account surplus. The United States, in turn, runs a current account deficit and finances that deficit by selling U.S. securities to the rest of the world, including the Chinese government. Many worry that this system is unsustainable. He said the current account deficit for the U.S. is about 6 percent of Gross Domestic Product, and so, effectively, the U.S. is borrowing that amount every year from the rest of the world. That requires the rest of the world to be willing to loan the U.S. the money. China is willing to loan (some of) the money, Melick said, because doing so helps keep the Chinese exchange rate from appreciating against the dollar. This in turn allows China to continue to export its goods and services.
“Now investors might be thinking that the system between the U.S and China might not work so well if something goes wrong in China,” Melick said. “Maybe the U.S. current account deficit is going to have to get corrected.”
If China becomes unwilling to loan the U.S. money, someone else will have to step up and loan the money or the U.S. has to change its ways and borrow less, he said. The default way to correct current account deficits is by going into recession. In a recession, less goods and services are imported. The current account deficit is relatively smaller, so there is less need to borrow to finance that deficit. Melick said any time investors suddenly start thinking the symbiotic relationship between the U.S. and China may come under stress and bring on a kind of painful adjustment, then share prices are going to fall.
“That painful adjustment is going to be a slowdown of the U.S. economy,” he said. “How do I then feel about my ownings of stock in the U.S. economy? They don’t look as hot. It may not actually be happening but maybe the risk of it happening is going up in people’s mind.”
Former Federal Reserve Chairman Alan Greenspan said earlier this week that a U.S. economy could fall into a recession later in the year.
Melick, who worked 11 years at the Federal Reserve in Washington, D.C., said Greenspan’s remarks echoed the view of many who believe there may come a time when the rest of the world gets tired of accumulating claims on the United States. He said many have been looking for signs of an upcoming adjustment for the past few years.
“So, boom, China’s stock market starts to fall and home prices are falling in the U.S.,” he said. “People start to say maybe this is the beginning of the adjustment, in which case the economy is going the be growing a little more slowly. So now’s a good time to sell to get ahead of everyone else who’s going to be coming to the same conclusion.”
Current Fed Chairman Ben Bernanke’s recent remarks that he expects the economy to grow moderately brought some investors back to the table on Wednesday.
Melick said Bernanke has been saying for some time that a painful adjustment isn’t an economic inevitability. This is the opposing view on the future of the balance of payments and trade in the global economy. Bernanke has been saying that a glut of savings in the world is what explains the U.S. current account deficit.
“The rest of the world is saving a ton of money and they have nowhere to put it,” Melick said, explaining Bernanke’s view. “So where do they put it? In the U.S. So of course the U.S. is getting capital inflows.”
“It’s clear the U.S. is enjoying capital inflows,” he said. “Why is that? Some say it’s because the U.S. is spending beyond its means. Other people say it’s because the rest of the world doesn’t have anything to do with its money but to put it in the U.S. economy.”