The Stabilization of the U.S. Economy Evidence From the Stock Market

Abstract

Until recently, economists widely believed that economic activity had become less variable in the United States following the end of World War II. Challenging this belief, new research suggests that key historical time series are spuriously volatile, a finding that is highly controversial. Data from the stock market may provide a vehicle for resolving the controversy. Economic theory relates stock prices to real activity; empirical tests also show a strong link between stock prices and activity. Financial data are accurately measured over long spans of time and hence are free of most of the measurement problems in other time series. Measures of stock prices show no stabilization in the post-World War II period relative to the pre-World War I or pre-Depression periods. These stock market data thus support the hypothesis that real activity has not been stabilized.