Occasionally, businesses are thought to have become pessimistic about the payoff from investment. On these occasions, they cut back on investment, producing a period of general economic weakness. Four examples include the US Great Depression in the 1930s, Japan in the late 1980s and the US and Euro areas in the late 1990s. In each case, the fact that business people had grown pessimistic is thought to have been reflected in weakness in the value of the stock market. To understand why, simply note two things. (i) Ownership of a firm’s stock gives one a right to part of that firm’s profits, so that the value of the stock market is the sum of the value of all firms’ stock. (ii) Businesses are the entities that have access to investment opportunities, and when investment opportunities look really good, then people naturally try to get a piece of the action. They do this by buying firms’ stock, and this drives stock prices up. Observations (i) and (ii) imply that when people revise downward their assessment about the payoff from investment opportunities, we can expect the value of the stock market to drop.


In the figure episodes depicted in the attached figure, the value of the stock market was initially rising, and then it fell. In each case, the line indicated by a star is the value of the stock market, divided by its value in the quarter when the stock market reached its peak value. The figure also shows investment (divided by the value of investment in the quarter of the stock market peak) and gdp (divided by the value of gdp in the quarter of the stock market peak).


The vertical axis is the same in each figure. Because of this, you can see that the percent movement in the variables during the US Great Depression was a lot bigger than what it was in the other three episodes. GDP fell by about 1/3 by 1933 (it was unity in 1929Q3, and around 0.66 in early 1933). Investment fell by a truly tremendous amount. It was unity in 1929Q3, and was at about 0.15 by early 1933. The stock market fell a lot too.


The other three episodes differ a little from the US Great Depression episode. In each case, investment continued to rise for a while after the stock market turned. One possibility is that this reflects that these episodes were much less severe than the first one. Investment requires making commitments long in advance. With the relatively milder shift towards pessimism in the later episodes, businesses may have chosen not to abandon investment projects that were already underway. (This stands in contrast with the Great Depression, when the drop in the stock market was enormous and investment projects were evidently abandoned immediately.) Instead, the evidence in the figures are consistent with the notion that firms in the later periods reacted to pessimism by simply not planning new investment projects. This would explain why it is that in the later period investment did not show weakness until several quarters after the stock market crash. In each case, when investment finally did weaken, there was a general weakness in economic activity.