Question

Richard Thaler, (Professor, The University of Chicago Booth School of Business) said: “We failed to learn from the hedge fund failures of the late ’90s.” His message (Links to an external site.)to overconfident risk managers: There’s more risk out there than you think.

a) What do you think of Wall Street (or any financial markets)? Do we need Wall Street? Why or Why not?

b) What is "The Paradox of Thrift"? How does that apply to our current situation?

Answer 1

Sol:

a)

The most important financial center in the world? A fabled place of silver spoons and golden parachutes? A hub of cut-throat capitalism? Or all of the above. Wall Street is many things to many people, and the perception of what it really is depends on who you ask. Although people’s views of Wall Street may differ widely, what is beyond dispute is its enduring impact not just on the American economy, but on the global one.

What Is Wall Street Anyway?

Wall Street physically takes up only a few blocks that amount to less than a mile in the borough of Manhattan in New York City; however, its clout extends worldwide. The term “Wall Street” was initially used to refer to the select group of large independent brokerage firms that dominated the U.S. investment industry. But with the lines between investment banks and commercial banks having been blurred since 2008, Wall Street in current financial parlance is the collective term for the numerous parties involved in the U.S. investment and financial industry. This includes the biggest investment banks, commercial banks, hedge funds, mutual funds, asset management firms, insurance companies, broker-dealers, currency and commodity traders, financial institutions, and so on.

Although many of these entities may have their headquarters in other cities such as Chicago, Boston, and San Francisco, the media still refers to the U.S. investment and financial industry as Wall Street or simply “The Street.” Interestingly, the popularity of the term “Wall Street” as a proxy for the U.S. investment industry has led to similar “Streets” in certain cities where the investment industry is clustered being used to refer to that nation’s financial sector, such as Bay Street in Canada and Dalal Street in India.

Why Wall Street Has Such an Impact

The U.S. is the world’s biggest economy, with 2019 gross domestic product (GDP) of $21.4 trillion, comprising 15% of global economic output. It is one and a half times the size of the second-biggest economy, China (2019 GDP = $14.3 trillion). In terms of market capitalization, the U.S. is the world’s biggest by some distance, comprising 40% of global market capitalization. Japan’s market is a distant second, with just over 7.5% of the global market cap.

Wall Street has such a significant impact on the global economy because it is the trading hub of the biggest financial markets in the world’s richest nation. Wall Street is home to the venerable New York Stock Exchange, which is the undisputed leader worldwide in terms of average daily share trading volume and total market capitalization of its listed companies. The Nasdaq Stock Exchange, the second-largest exchange globally, also has its headquarters on Wall Street.

How Does Wall Street Have Such an Impact?

Wall Street affects the U.S. economy in a number of ways, the most important of which are as follows:

• Wealth Effect: Buoyant stock markets induce a “wealth effect” in consumers, although some prominent economists assert that this is more pronounced during a real estate boom than it is during an equity bull market. But it does seem logical that consumers may be more inclined to splurge on big-ticket items when stock markets are hot and their portfolios have racked up sizable gains.
• Consumer Confidence: Bull markets generally exist when economic conditions are conducive to growth and consumers and businesses are confident about the outlook for the future. When their confidence is riding high, consumers tend to spend more, which boosts the U.S. economy since consumer spending accounts for an estimated 70% of it.
• Business Investment: During bull markets, companies can use their pricey stock to raise capital, which can then be deployed to acquire assets or competitors. Increased business investment leads to higher economic output and generates more employment.

Global Bellwether

The stock market and the economy have a symbiotic relationship, and during good times, one drives the other in a positive feedback loop. But during uncertain times, the interdependence of the stock market and the broad economy can have a severely negative effect. A substantial downturn in the stock market is regarded as a harbinger of a recession, but this is by no means an infallible indicator.

For example, the Wall Street crash of 1929 led to the Great Depression of the 1930s, but the crash of 1987 did not trigger a recession. This inconsistency led Nobel laureate, Paul Samuelson, to famously remark that the stock market had predicted nine of the last four recessions.

Wall Street drives the U.S. equity market, which in turn is a bellwether for the global economy. The 2000-02 and 2008-09 global recessions both had their genesis in the U.S., with the bursting of the technology bubble and housing collapse, respectively. But Wall Street can also be the catalyst for global expansion, as is evident from two examples in the current millennium. The 2003-07 global economic expansion commenced with a huge rally on Wall Street in March 2003. Six years later, amid the biggest recession since the 1930s depression, the climb back from the economic abyss started with a massive Wall Street rally in March 2009.

Why Wall Street Reacts to Economic Indicators

Prices of stocks and other financial assets are based on current information, which is used to make certain assumptions about the future that in turn form the basis for estimating an asset’s fair value. When an economic indicator is released, it would usually have little impact on Wall Street if it comes in as per expectations (or what’s called the “consensus forecast” or “analysts’ average estimate”). But if it comes in much better than expected, it could have a positive impact on Wall Street; conversely, if it is worse than expected, it would have a negative impact on Wall Street. This positive or negative impact can be measured by changes in equity indices like the Dow Jones Industrial Average or S&P 500, for instance.

For example, let’s say that the U.S. economy is coasting along and payroll numbers that are to be released on the first Friday of next month are expected to show that the economy created 250,000 jobs. But when the payroll report is released, it shows that the economy only created 100,000 jobs. Although one data point does not make a trend, the weak payroll numbers may lead some economists and market-watchers on Wall Street to rethink their assumptions about U.S. economic growth going forward. Some Street firms may lower their forecasts for U.S. growth, and strategists at these firms may also reduce their targets for the S&P 500. Large institutional investors who are clients of these Street firms may choose to exit some long positions upon receiving their lowered forecasts. This cascade of selling on Wall Street may result in equity indices closing significantly lower on the day.

Why Wall Street Reacts to Company Results

Most medium to large-sized companies are covered by several research analysts who are employed by Wall Street firms. These analysts have in-depth knowledge of the companies they cover and are sought after by institutional “buy-side” investors (pension funds, mutual funds, etc.) for their analysis and insights. Part of analysts’ research efforts are devoted to developing financial models of the companies they cover and using these models to generate quarterly (and annual) revenue and earnings per share forecasts for each company. The average of analysts’ quarterly revenue and earnings per share (EPS) forecasts for a specific company is called the “Street estimate” or “Street expectations.”

Thus, when a company reports its quarterly results, if its reported revenue and EPS numbers match the Street estimate, the company is said to have met Street estimates or expectations. But if the company exceeds or misses Street expectations, the reaction in its stock price can be substantial. A company that exceeds Street expectations will generally see its stock price rise, and one that disappoints may see its stock price plunge.

Wall Street Criticisms

Some criticisms of Wall Street include:

• It is a rigged market: Although Wall Street operates fairly and on a level playing field most of the time, the convictions of Galleon Group co-founder, Raj Rajaratnam, and several SAC Capital Advisors on insider trading charges, reinforce the perception held in some areas that the market is rigged.
• It encourages skewed risk-taking: The Wall Street model of business encourages skewed risk-taking since traders can make windfall profits if their leveraged bets are right, but do not have to bear the huge losses that would result if they are wrong. Excessive risk-taking is believed to have contributed to the meltdown in mortgage-backed securities in 2008-09.
• Wall Street derivatives are WMDs:Warren Buffett warned in 2002 that the derivatives developed by Wall Street were financial weapons of mass destruction, and this proved to be the case during the U.S. housing collapse when mortgage-backed securities went into free-fall.
• Wall Street can bring the economy to its knees: As discussed earlier, and as seen in the Great Recession of 2008-09.
• Too Big To Fail rescues need taxpayer funds: Giant Wall Street banks and firms that are deemed “Too Big to Fail” would need taxpayer funds if they are in need of a rescue.
• Disconnect from Main Street: Many see Wall Street as a place where unnecessary middlemen abound, who are very well paid despite not generating value for the real economy like Main Street does.
• Wall Street arouses envy in some and anger in many: Million-dollar payouts that are quite common on Wall Street arouse envy in some and anger in many, especially in the aftermath of the 2008-09 recession. For example, “Occupy Wall Street” claimed in its manifesto that it “is fighting back against the corrosive power of major banks and multinational corporations over the democratic process, and the role of Wall Street in creating an economic collapse that has caused the greatest recession in generations.”

The Bottom Line

Wall Street consists of the largest stock exchanges, the largest financial firms, and employs thousands of people. As the trading hub of the world’s biggest economy, Wall Street has an enduring impact not just on the American economy, but also on the global one.

b)

People save for various reasons. Some save with a specific purchase in mind, such as cosmetic surgery or a Porsche, while others save just to have more money. Economists say that individuals save to buy durable goods and/or accumulate wealth to maintain a certain lifestyle during retirement or in times of financial uncertainty. These reasons all confer benefits to a saver. In the near term, the saver can finally buy the latest and greatest gadget, and in the long term, the saver can be more financially secure during retirement or unplanned unemployment.

Normally, personal saving declines during recessions because people want to maintain their existing level of consumption. During the Great Recession, though, saving increased. The chart shows the personal saving rate, the year-over-year growth rate of gross domestic product (GDP), and recession periods from 2000 to 2011. Before the Great Recession, the average saving rate for the typical American household was 2.9 percent. Since the recession started in 2007, the average saving rate has risen to 5.0 percent. This increase was largely driven by uncertainty about future employment, efforts to reduce debt, and wide fluctuations in stock and housing prices. Although this increase in saving benefits individuals who save more, some economists argue the dramatic change in saving behavior is detrimental to the overall economy. Given the benefits to individuals, how could saving harm the economy?

John Maynard Keynes, who published his influential work, The General Theory of Employ­ment, Interest, and Money, in 1936, noted saving can ultimately be detrimental to the economy because of the paradox of thrift. This theory argues that if everyone individually cuts spending to increase saving, aggregate saving will eventually fall because one person's spending is someone else's income. Because increased saving, by definition, decreases current consumption, it stifles demand.

A simple example can illustrate this paradox. Let's assume I want a new computer, so I start saving an extra $100 each month that I would otherwise spend going out to eat. By choosing not to spend that $100, I deny the wait staff at my favorite restaurants some work hours and tips (i.e., some portion of their income). As a result, these workers also have to reduce their consumption because they are earning less. If society (as opposed to an individual as in our example) follows this saving pattern, this snowball (or Keynesian multiplier) effect could ultimately lead to decreased consumer spending and lower income for everyone. Consequently, Keynes argued, output would decrease and, therefore, limit economic growth/recovery until, of course, I bought my new computer with the money that I've saved.

In the Great Recession, the increase in the number of adult children (25 to 29 years of age) living with their parents is also a good example of the paradox of thrift. According to the Census Bureau's "Families and Living Arrangements" dataset, the percentage of 25- to 29-year-olds living with their parents increased from 14 percent in 2005 to 19 percent in 2011.2 This arrangement allows them to save money on rent/mortgages, utilities, cable, and furniture. However, because the addition of just one new household contributes an estimated $145,000 to the economy when one factors in multiplier effects,3 the rise in the number of twentysomethings living with their parents could have deprived the economy of up to $25 billion per year during this period. Even if this is accurate, it's a very small share of a $15.3 trillion economy. In the short run, then, some could argue that this choice by young adults to save slows not only the housing market, but also the retail, construction, and manufacturing industries.

These two examples illustrate that saving can have unintended consequences because one person's consumption is another person's income. During recessions, decreases in consumption could inhibit economic recovery. However, in the long run, the accumulated money from individual savers is available for capital investment, a situation where businesses borrow to purchase capital (e.g., machinery and technology). Thus, an increase in the saving rate increases capital investment (e.g., investment in machinery for production). Such increases in capital stock ultimately lead to higher levels of business productivity and growth. Because economists are largely concerned with long-run growth and economic theory notes the positive aspects of increased saving, the paradox of thrift remains a controversial concept. So ultimately, it is OK to save for that big purchase since future consumption benefits both you and society.