Americans are Unduly Afraid of Stock Market Crashes

At least we got a tax cut

Americans have an inordinate fear of stock market crashes, sort of like Germans' inordinate fear of inflation, and for much the same reason.  Just as the great inflation is a powerful German folk-memory, the 1929 crash leading to the Great Depression is a folk-memory with us.
The Germans need to get over it and so do we.  German inflation aversion played a major part in Europe's persistent economic crisis, as Germans refused to accept a little more inflation, instead pulling everyone else down.  As for our fear of stock market crashes -- well, Trump and Mnuchin are exhibits 1 and 2.

The stock market crash of 1929 was a financial crisis.  All financial crises are the same underneath -- the are the result of excessive leverage, i.e., debt-to-equity ratio.  As prices of collateral become inflated, debt builds up that seems well secured until collateral prices fall back to reasonable rates.  Then suddenly a lot of debt that seemed well secured turns out not to be at all.  Lenders are stuck with a lot of bad debt. Borrowers are stuck with a lot of unpayable debt.  And investors find that their investments are suddenly worth only a fraction of their former value -- with disastrous results for their budgets.  The stock market crash of 1929 was such a financial crisis.  The economy was heading for recession even without the financial crisis, but financial crises make recessions worse, and greatly slow recovery.

But guess what.  We responded to the 1929 stock market crash by instituting the Securities Exchange Commission (SEC), barring commercial banks from issuing securities, insuring deposits, and other measures to prevent a repeat.  And it worked.  Since then we have had recessions and stock market crashes, but never again have we allowed a stock market crash to bring down the economy in the way that it did in 1929.

Our worst single day loss on the stock market in percentage terms (the best measure) was not in 1929 at all, but in 1987. On that day stocks fell by 22.6% -- nearly as much as the combined losses of the worst two days in 1929.  For anyone who has never heard of the 1987 crash, that's OK.  The various buffers put in place since 1929 worked.  The Fed lowered interest rates and the economy never so much as missed a beat.  (The stock market, seeing the real economy chugging along without it, got up, brushed the dust off, and resumed rising).

In 2008 we experienced our worst financial crisis since 1929 and, unsurprisingly, stocks dropped and the economy fell into its worst downturn since the 1930's.  But falling stocks were merely a symptom, not a cause, of the downturn.  The overpriced collateral that led to the crisis was real estate.  And, it should be noted, we instituted reforms following that crash to prevent banks from overextending themselves that appear to be working.

The one time since 1929 that a falling stock market really did damage the real economy was in 2000.  As the neighboring graph shows, the 2000 stock bubble (expressed in terms of price-to-earnings ratio) was immense -- great enough to dwarf the 1929 bubble.  Yet the downturn was mild (if persistent).

So really, folks, our economy has learned to weather stock market crashes.  To the extent that they are a symptom of underlying problems in the real economy, stock market crashes can be worrisome.  But we have insulated ourselves from stock market crashes to the extent that the worst one-day drop ever had no effect at all on the real economy and even a bubble as massive as the one that burst in 2000 caused only modest damage. 

So please, guys, a little worry is reasonable.  A total freakout is completely uncalled for.