Why Don’t We Worry About the Stock Market In Macroeconomics?

The big news the first week of class is the ongoing crash of Chinese stock markets. Here’s an excellent chart that appeared on the front page of Friday’s issue of The New York Times:

Interestingly, the “big” crash of this week is just at the end there. There were actually quite a few of these last summer.

This was a big enough deal that some of the students in class knew the news off the top of their heads. And pretty much everyone in the class was aware of, or believed, the urban myth that stock market crashes cause recessions.*

Now, stock markets are not uninformative about future macroeconomic outcomes. But, like most leading indicators … they’re not really very good on their own, and they don’t improve much when we combine them together. Instead, business cycle peaks and troughs remain highly unpredictable.

The terminology of medical testing is useful here (because most people are familiar with it, but don’t get that it represents some pretty serious underlying statistical thinking). What we’d like to see out of a medical test is (true) positives and (true) negatives. A (true) positive means that the test tells you that you have the disease when you really do. A (true) negative means that the test tells you that you don’t have the disease when you really don’t have it. All tests deliver some true positives and negatives. What differentiates a better test from a worse test is how many false positive and false negatives it has. A false positive means the test says you have the disease when you don’t. A false negative means the test tells you that you’re healthy when you’re not.

The problem with using the stock market as a predictor of the real economy is that it delivers a real lot of false positives and false negatives. Paul Samuelson, who won the Nobel Prize in 1971, said this best in an interview in Newsweek in 1965:

The stock market has forecast nine of the last five recessions.

The bottom line is that you should keep an eye on the Chinese (and other) stock markets, but don’t worry about it too much.

* “Urban myth” is the current slang for this sort of thing. But in economics, when we worry about whether people believe things that may or may not make economic sense, but which don’t have a very solid foundation, we call it “folk economics”.