The stock market is a staple of the news and is often seen as a bellwether of the health of the economy, but it’s not always clear just how meaningful that connection is to the real world.  Does a booming stock market drive consumer spending, for instance?

New research from MIT set out to find out, and showed that while the stock market appears to have a fairly modest effect on the wider economy, there is a clear effect nonetheless, with around 3.2% of consumer spending a result of the stock wealth they possess.

“We found that the empirical effect is clear,” the researchers say. “Nontradable industry activities go up, including labor compensation in these nontradable industries. That provides direct evidence policymakers should care about.”

Cause and effect

The researchers examined a wide range of data sources to try and understand the relationship between rising stock wealth and economic activity.  Was the relationship causal or independent?

One of the more interesting findings is in terms of nontradable industries, where location was hugely important.  For instance, sectors like restaurants and construction tend to be nontradable, whereas manufacturing is generally far more tradable.

As such, the authors argue that a 20% rise in share prices can increase the national labor bill by around 1.7% and the number of hours worked by 0.7% within a couple of years.  The impact is most definitely not immediate, however, with changes beginning to emerge after around a quarter from the original market event, and then peaking one or two years afterward.

“We do find a time lag,” the researchers say. “Which is natural, because financial markets move fast, but the real economy is slower. Perhaps it takes time for people to realize their wealth has changed or for their consumption habits to adjust. Or, once people start spending, restaurants take a while to adjust labor hours or compensation. It’s a demand-driven mechanism.”

Policy implications

The authors believe that their findings have clear policy implications, especially for central banks.  They suggest that their work reinforces the notion that lowering interest rates not only encourages greater business borrowing but also boosts consumer spending through greater stock wealth.

“One of the things the Fed can do, if they want to stimulate economic activity, is cut the rate and increase stock wealth, and that will support economic activity,” they say.

Such moves have not always been popular in the past, with observers often suggesting that these kinds of policies were too friendly to investors.  It’s a fear that the researchers believe is not warranted.

“It’s not so obvious that it’s a bad thing. If you don’t do that, according to our evidence, it would be a negative economic shock, and the Fed is not [necessarily] doing it to bail out the stockholders, but is doing it to support economic activity,” they say.

That’s not to overlook the various moral debates around the level of wealth tied up in stocks, of course, but the researchers hope that their work provides some empirical evidence to underpin policymaking in the future.