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YOU DECIDE: What's behind the stock market turmoil?

August 24, 2007

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

Dr. Mike Walden
Media representatives: For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

There's no question the public's interest in talking to economists rises with bad news.

Ever since the stock market got the "wobbles," my phone has been ringing with questions about recessions, slowdowns and economic bad times. People rightly want to know what the sell-off in the market and the associated credit problems in housing and mortgages mean for their economic future.

There's a joke that goes, "Economists are good at predicting the past, but no more than average at forecasting the future."

I think that's fairly accurate. If economists have an advantage, it's in helping folks understand the fundamental forces that are driving the economy. So now that I've reduced your expectations of what I can deliver, here are my answers to questions about the recent turmoil in the financial markets.

Things had been going so well with stocks, with record highs. What sparked the recent sell-off?

There are two possible answers. One is that the stock market got ahead of itself, and rose too high, too fast. When cooler heads prevailed, a "correction," meaning a decline of 10 percent or more, was due. This is not unusual. There's a lot of psychology behind stock investing, and investment markets don't move in straight lines.

The other answer is that problems in the mortgage credit market were the cause. With mortgage bankruptcies rising, and with mortgages now a part of many more investment portfolios than in the past, problems in mortgage loans can quickly spread to many investors and many companies.

Why have mortgage bankruptcies gone up?

With interest rates at generation lows and plenty of money available to lend, home buying and mortgage lending skyrocketed this decade. Unfortunately, some borrowers have been hurt by a two-pronged trap.

First: Interest rates rose during the past two years, and if the borrower used an adjustable rate mortgage, they found payments also have risen to, perhaps, an unaffordable level.

Second: It's taking longer now to sell a house, so borrowers with payment problems may not be able get out of the loan before bankruptcy hits.

Aren't falling housing prices contributing to the problem?

Actually, the best measure of home prices, which compares prices of the same houses over time, continues to show prices going up, although at a slower pace than in the past. The slowest gains are in the New England states and the Midwest. Same-house prices in the South are rising at 4-to-5 percent annually. Of course, these data only include homes that actually sold. It may be that homes with slower gains or price declines haven't sold and therefore aren't recorded.

Still, isn't a fundamental problem that American households are overburdened with debt, and this makes their financial situation "iffy" at best?

It is true that household debt has increased, but debt is only one side of the financial picture. The other side is assets, or the value of investments. The difference between household assets and household debt is net worth. On average, household net worth is more than five times greater than household income, and this measure trended higher this decade.

Certainly, the financial picture isn't rosy for all households. Household net worth is a much smaller multiple of income for lower-income households, and there are many households whose debt exceeds their assets. But from an economy-wide perspective, household finances still look strong.

What role does the government have in this?

The government, but specifically the Federal Reserve, can ease financial tensions by making loans to banks and by simply printing more money. In fact, the Federal Reserve has done some of this in the past weeks.

But there are two potential downsides to such actions. Some say the issues behind the stock market jitters should take care of themselves. This viewpoint believes bad loans should go under and investors in those loans should lose money. More broadly, pumping more money and credit into the economy runs the chance of creating higher inflation later.

Have I made you feel better? Maybe, maybe not. Have I provided any infallible forecasts? Probably not. Have I increased your understanding of what's been driving some of the ups and downs in investment markets?

The answer, I hope you'll decide, is yes.

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ces.ncsu.edu/depts/agcomm/writing/walden/index.html

Posted by Dave at August 24, 2007 08:39 AM