On Monday, February 5th, the Dow Jones Industrial Average experienced the worst single-day point decline in history, plunging by almost 1,600 points. As the day progressed buyers were able to staunch the bleeding, but at the time of closing the Dow was still down 1,175 points, its worst closing point decline on record.
So, what does this mean? Are we about to plunge into another nightmare scenario, another 2008-era scourge of unemployment, bankruptcy, and billions in losses? Is it time to succumb to paranoia?
Well, not exactly.
Not every market plunge is cause for alarm, although it is true that most financial crises have begun with a market plunge. So how can we tell whether this little hiccup in the markets is an isolated incident, or the start of something much worse?
The answer lies, surprisingly, in the field of psychology.
Recessions occur when a little slowdown in spending in an economy feeds on itself. One drop in the index, and businesses are a little more cautious in their hiring, and vulnerable workers do a little more precautionary saving. This causes businesses to become even more cautious, and so on, and so on, until you eventually have a recession on your hands. They don’t magically appear out of nowhere, but rather, occur when everyone is worrying and saving all their money, the banks run out of money, and the economy itself gets stuck in a downturn. The recession is essentially an outbreak of collective fear.
Governments and economists have been aware of these trends for years. They have also realized that these outbreaks of fear can be fought, by persuading everyone that their worry is unsubstantiated, and that things are actually fine. To convince citizens that they should go back to being cheerful and optimistic (and freely spending their money, in order to keep the economy rolling), governments can replace the lost spending directly by increasing their own spending, or the central bank can set public policy targets that they aim to hit, such as changes in interest rates.
In other words, keeping an economy out of recession is just as largely a matter of psychology as it is based on actual policy. It’s about coordinating everyone’s expectations, so that everyone believes the economy will adapt to minor hiccups and continue chugging along.
So, if governments and banks know how to keep people optimistic, why do recessions even happen? Certain unexpected events can drastically change the mood for the worse. A bank failure that people didn’t see coming. Or a spike in the price of oil. Or… a dramatic drop in stock prices. But in the case of the latter, additional extenuating circumstances are often necessary, such as the common notion that the economy is “due” for a downturn after an extended period of prosperity, or the idea that the government or central bank might not quite be prepared to swing into their usual “mood-elevating” activity.
If the people lack trust in the government in some of these crucial times, then by the time these institutions realize the shift in mood it is too late, and the economy is already in a downturn. This is at least partially what happened with the mortgage boom of the 2000s, leading up to the 2008 subprime mortgage crisis.
But, going back to Monday’s drop, thankfully it is hard to conceive that such a plunge could shake economic sentiment enough that we would actually be facing any real problems. This is also particularly true for us in Canada; we aren’t as tied to the fate of the markets as our Southern neighbours. If you were to ask me personally, I’d predict that within a few more days the events of the 5th will practically be forgotten by the resurgence of the usual ups and downs of the Dow Jones.
These stock market dips are probably nothing. But then again, they usually are, except for the times when they aren’t.
