How Stock Market Crashes Work
For those who wonder how stock market crashes hurt an economy, they really don’t: They are a symbol of an already damaged economy. Here’s a simplified look at it:
– The economy is doing well – investments make money.
– In order to make larger investments people borrow (margin), making their returns on the growing economy larger.
– These positive returns motivate others to do the same, seeking out their own similar investments. The competition to invest in the hot sector of the economy thus drives up prices which is fueled by the credit. Sometimes this is exacerbated by monetary policy which increases available credit.
– This results in the value of these investments going up faster than the returns on the underlying enterprise, driving more people to invest chasing returns (more credit available makes this effect more dramatic).
– This drives capital away from other sectors of the economy since the capital is chasing the returns in the hot sector.
– This misallocation of capital (too much capital here, not enough capital there) has effects in the real economy. Once this becomes apparent, investors back off dropping the value of the hot investment.
– People who leveraged too much are forced to sell to avoid a margin call, i.e. bringing more money to keep their loan afloat.
– For this reason the value drops, forcing more people to sell to avoid more margin calls. Welcome to the Crash. But the crash itself is a result of the market finally realizing that the real economy’s returns don’t match the kind of valuations investors placed on the hot investment. However it affects all prices since people are selling everything to avoid margin calls, making many other investments super cheap and undervalued.
– Now, the after effect is that the losses scare financial institutions from lending and risk, which will create a period of a liquidity crunch – people having a hard time being able to borrow money or find buyers for their investments (at least at the prices they believe they should get).
– All the investments that don’t have the underlying returns to match their market values have to be repriced, affecting investors’ net worth. The liquidation begins.
– Once assets are repriced and realigned with the real economy, the economy can move forward again. Banks feel comfortable lending again and are people willing to buy those formerly unsellable assets. This, assuming this was allowed to happen; given that political pressure to protect people’s existing net worths often pushes politicians to prevent assets from being repriced and supporting their current prices, thus postponing the economy from recovering.
The point is that stock prices are only symbols of intersection of investors’ perspective on investments and the real economy, not the driver of the economy itself.
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