Stock market collapse causes a depression
Willems ’17 (Atle Willems – MA with distinction in Finance @ Nottingham University Business School, Economic Advisor at Larvik Kommune, Economic Analyst at Liabridge Economic Research, “How A Stock Market Sell-Off Can Trigger A GDP Recession,” 20 March 2017, https://seekingalpha.com/article/4056561-stock-market-sell-can-trigger-gdp-recession)
With stock market prices hitting new highs despite interest rate- and money supply headwinds, this is a timely opportunity to explore how a stock market sell-off may trigger a GDP recession ("recession").
A recession may come about in many ways. But since GDP (nominal and real) is largely a reflection of the level of debt-inflated consumer spending, changes in the supply of money and consumers' time preferences (i.e. the spending vs. saving decision) always play major roles. These two are also capable of bringing about a stock market correction since broad-based increases in stock prices over time are driven by monetary inflation and a reduced demand for money to hold (i.e. decreased demand for cash balances). Our focus here will however be on how a stock market sell-off may trigger a recession.
First and foremost, crashing stock prices affect economic developments as they so utterly destroy the shaky foundation an elastic money supply and fractional reserve banking to a large extent are built on; confidence. In his book about the great depression Chester Phillips writes (p. 161),
The stock market crash provided the shock to confidence which definitely and dramatically started the depression on its downward course, revealing to most persons for the first time the inherent instability of the conditions which had prevailed for several years.
In this sense, falling stock prices can act as recession or depression triggers. That is however all they are: it is not actually falling stock prices that cause the recession, but rather the factors that brought about the preceding bull market. This sheds light on why surging stock prices over time is a leading recession indicator. A stock certificate trading on the stock exchange (or anywhere else) is not itself wealth. Rather, it is a claim on the wealth (expected to be) generated by the company it represents. Therefore, changes in the market price of a stock merely represent a change in the valuations of an already existing asset.