In an era of bubbles, crashes, tarnished reputations, and outrage over the gulf between the wealthy and the struggling classes, it may seem like the height of insolence to suggest that stock markets hold the key to economic recovery in the United States and Europe. Wasn't it market misbehavior that got us into this mess in the first place? But, in fact, policymakers would still do well to look to the stock market as an essential indicator of the likely impact of their reforms.
Stock market reactions to economic reforms provide powerful forecasts of policy effectiveness because changes in stock prices reflect the average opinion of thousands of shareholders who care little for ideological debates and simply consider whether a given change will create or destroy value. This predictive ability makes market movements an important complement to the traditional backward-looking measures Washington is fond of, including growth, inflation, and unemployment.
In particular, policymakers in the United States and Europe need to study the movements of markets over the last few decades in what we used to call the "Third World." With Europe back in recession and the United States offering temporary solutions to its problems that inspire little confidence, advanced countries sorely need a new direction. By enacting large, unprecedented policy changes over the last three decades, developing countries turned around their economies and became the "emerging markets" that now drive global growth. Historical analysis of stock price reactions to policy-reform announcements made by governments in emerging economies across the globe demonstrates repeatedly that decisive, clearly communicated plans to implement market-friendly policies are what drive growth and create value -- not just for shareholders but for all.
When it comes to the debate in Western countries over the merits of austerity versus stimulus, for example, emerging economies' stock markets show us that one size does not fit all. In countries where large, persistent deficits have seduced governments into monetizing their debts and have spawned runaway increases in the cost of goods and services, the stock market tells us that austerity or "cold-turkey" policies designed to stop spiraling inflation dead in its tracks are both necessary and desirable. In contrast, equity markets react extremely negatively to government policies that doggedly pursue fiscal austerity when inflation is not out of control.
Take Brazil. In 1994, then-Finance Minister Fernando Henrique Cardoso enacted a radical stabilization program to eliminate inflation. The government introduced a new currency and abruptly stopped printing money to pay its bills. In the course of just one year, the country's Bovespa stock market index jumped 75 percent as a result of the policy change. The market anticipated the program's success and was ultimately proved correct. In just three years, Brazil's inflation rate dropped from 3,000 percent to the single digits. As a result of the fall in inflation, lower deficits, and greater openness to flows of goods and capital, the economy took off by the first decade of the new millennium. Between 2001 and 2011, growth and the implementation of anti-poverty measures lifted 20 million Brazilians out of poverty and into the country's growing middle class.
In contrast to the situation in Brazil, the stock market tanked in Chile when the government decided to implement austerity measures under three successive agreements with the IMF between 1983 and 1989. Because inflation was not the major economic issue facing the country at that time -- Chile needed to rebuild its financial system, reduce import tariffs, and make its exchange rate more competitive -- the announcement of cold-turkey approaches to macroeconomic stabilization triggered an average 87 percent drop in the stock market in each of the 12-month periods preceding these IMF agreements. Consistent with the market's gloomy forecast, real GDP fell sharply with the onset of austerity and did not return to its pre-recession level until 1986.
Moving beyond Brazil and Chile, between 1973 and 1994, the stock market indices of 21 emerging countries jumped an average of 44 percent in response to announcements of austerity programs implemented in the midst of high inflation. In countries with only moderate inflation, however, markets fell an average of 24 percent when governments pursued austerity.
Given that the inflation rate for the United States, the eurozone, and other advanced economies in 2012 was less than 2 percent, the implications of these stabilization lessons for First World fiscal policy seem straightforward. Attempting to balance budgets in the eurozone by 2014, as called for by the European fiscal compact that came into force this Jan. 1, would require a drastic swing in investment and consumption that would exacerbate the region's economic woes. Instead, European countries should adopt a long-term target for fiscal deficits along with clear and credible measures to drive a process of gradual deficit reduction. The United States, having avoided a free-fall off the fiscal cliff at the start of 2013, also needs to resist radical attempts to eliminate its deficit overnight.