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Could a Stock Market Crash Cause a Recession?

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Worried Stock Trader

A trader works on the floor of the New York Stock Exchange (NYSE) September 30, 2008 in New York City.

Credit: Spencer Platt/Getty Images
1929-crash.jpg

29th October 1929.: Workers flood the streets in a panic following the Black Tuesday stock market crash on Wall Street, New York City.

Photo: Hulton Archives/Getty Images

On September 15, 2008,  the Dow Jones Industrial Average dropped 500 points, the worst drop since the bottom of the 2001 recession. U.S. Treasury Secretary Henry Paulson's refusal to bail-out Lehman Brothers threw the markets into a crisis of confidence. That's because financial companies knew they would be forced to eat the losses they sustained from the Subprime Mortgage Crisis.

As the value of these financial companies' stocks fell, they knew they would have a harder and harder time raising new capital to both cover their losses, and make new, good loans. In this way, thje stock market decline threatened to put these banks out of business if they didn't have sufficient reserves to cover this downturn. This, in and of itself, could have put the economy into a bona-fide recession.

Since stocks are a piece of ownership in a company, the stock market reflects investors' confidence in the future earnings of all these companies. Since corporate earnings are dependent on the health of the U.S. economy, the stock market is also an indicator for the U.S. economy itself.

What is a stock market crash?  A great example is what happened the week beginning October 5 2008, when the Dow fell from over 10,000 to below 8,500, a 15% decline in one week. It signals a sudden loss of confidence in both the market and the underlying economy.

If confidence is not restored, it could contribute further to recession, as happened in 2000. That's because declining stock values means less wealth for consumers, whose purchases drive 70% of the economy. (See "What Are the Components of GDP?"). It also means less financing for new businesses, since the sale of stocks is one way that companies can get the funds needed to grow. (See How Do Stocks and Stock Investing Affect the U.S. Economy?")

Last, but certainly not least, a declining stock market could eventually lead to a slowdown in the global economy. That is because the U.S. economy provides 20% of the world's output. (See "The Power of the U.S. Economy")

On the other hand, if it is not sustained, it could only serve as a warning sign of a loss of investor confidence. For example, in Q1 2007 the Dow fell over 600 points in a little over a week. However, it recovered during the year, and went on to a high of 14,000 in October. Although the crash did not cause a recession itself, it did signal that one was coming.

The only way to tell if a stock market crash is helping to cause a recession is to closely follow economic indicators for six months to see if it's signaling an approaching economic downturn.

How It Affects You

What should you do to protect yourself? First off, don't panic. The bottom of a bear market looks just like what we are seeing: huge swings and volatility, panic, and doom-and-gloom predictions from economists. A recession does not a depression make, and there is always economic growth in other parts of the world, such as China, India and Southeast Asia, Brazil, Chile and some Central European countries. Closely follow economic indicators to see where the economy is headed. .

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