Thu, Jun 15, 2006 - Page 9 News List

Current market weakness is much more than a policy issue

By Robert Shiller

Stock markets in much of the world have shown sharp cumulative declines since around May 10, with most of the drop occurring in the two-week period to around May 23, but with prices continuing to fall on average since then. Does trouble in the world's stock markets mean trouble for the world economy?

Let us look at the biggest declines. Of the major countries' indexes, the biggest crash was in India, where stock prices fell 16.9 percent from May 10 to May 22. The debacle on the other side of the globe was almost as big, and the peaks and troughs were within a day or two of those in India: In Argentina stock prices fell 16.1 percent, in Brazil, they fell 14.7 percent and in Mexico they fell 13.8 percent.

European markets also suffered large losses. In Sweden, stock prices fell 15.2 percent between May 9 and May 22; over nearly the same period prices fell 9.7 percent in Germany, 9.4 percent in France and the UK, and 9.3 percent in Italy. Likewise, in Asia, stock prices fell 11.5 percent in South Korea, 9.3 percent in Hong Kong, and 8 percent in Japan from their respective peaks to troughs over very nearly the same time period.

Many commentators try to tie such events to developments in the US. But US stock prices fell only 5.2 percent between May 9 and May 24. Nor does China appear to be behind the global decline, since stock prices there actually rose during this period.

Economists' standard explanation revolves around monetary policy. In the wake of the great deflation scare of 2003, central banks around the world cut interest rates, setting off speculative booms in both stock and housing markets. But now, according to this view, rising interest rates are beginning to bite, which portends further declines in asset prices.

There is certainly an important element of truth in this argument. The US Federal Reserve did indeed raise rates on May 10, and its chairman, Ben Bernanke, indicated then that there may be further rate increases in the future. Worsening US inflation data were reported on May 17, suggesting that further monetary tightening is in store.

Economists like to view the world as logical and manageable, which implies that they understand what is happening. But, in doing so, they often exaggerate central banks' role. Indeed, the US rate increase was just one in a series of rate hikes -- the 16th in a row. No other major central bank raised rates after the stock market drops began last month until June 7-8, when several did (the European Central Bank, India, South Korea, South Africa, Thailand and Turkey).

Another factor is the price of oil, which rose 24 percent from March 22 to May 2, setting all-time records along the way. Surely, this was a major event that would plausibly affect stock markets all over the world. Oil price increases have been a culprit in virtually every economic recession since World War II.

Still, the oil price increases do not correspond to the time interval in the middle of last month when stock market indexes fell most sharply. To argue that oil price increases caused the stock market declines presupposes a time lag of several weeks.

But stock markets are not very logical, and there could be a lagged response to the oil price shocks. As with any other prices in financial markets, an increase attracts attention. When oil prices rise quickly, people watch the news related to oil prices and talk to each other more about oil prices, hence creating heightened sensitivity to this news.

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