Stephen King: We're all more optimistic about the future

The man and woman on the street are spending with abandon
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The Independent Online

Keynes' famous animal spirits are alive and kicking. First, we had the mega-optimism of 1999 and 2000 when equity markets soared into the stratosphere. Then we had the extraordinary pessimism of 2001 when, one after another, markets came crashing down.

Keynes' famous animal spirits are alive and kicking. First, we had the mega-optimism of 1999 and 2000 when equity markets soared into the stratosphere. Then we had the extraordinary pessimism of 2001 when, one after another, markets came crashing down.

This change in animal spirits – with the bears in the ascendant over the bulls – suggests there has been a massive shift in expectations regarding the future path of the world economy. Equity markets, after all, are supposedly meant to discount the future. Back in 1999, the future was bright but it certainly isn't anymore. Animal spirits have changed dramatically, so much so that not even Rolf Harris and his team at Animal Hospital will be able to come up with an immediate cure.

Despite all this, the man and woman on the street – or, these days, in Bluewater or Brent Cross – are spending with abandon. Equity markets may be saying that the end (at least of the new paradigm) is nigh, but consumers are, apparently, indifferent. As long as they can borrow, as long as they can put things on a piece of plastic, then they are happy to go on spending. Yet there is mounting evidence to suggest that consumers ultimately are bothered by falls in equity prices. There are a number of possible links but two stand out above all others. First, consumers can be directly affected by falls in equity prices if they happen to own a lot of equities. Second, consumers can be affected indirectly if the fall in equity prices presages a collapse in profits. After all, falling profits are a lead indicator of rising unemployment and falling wages.

In the first case – where falling equities imply a loss of financial wealth – consumers may choose to save more to compensate for the loss in wealth in the form of equities. In the second case – where falling equities tell you something about future profits – consumers may choose to save more because they recognise that their human capital is at risk, in the form of lower bonuses, wage cuts or higher unemployment.

For 2002, both of these factors are likely to be key issues affecting the performance of the major industrialised economies. The losses in financial wealth have been particularly large in the US where consumers, proportionately, own a lot more equities than they do elsewhere. Consumers have not, yet, given up spending altogether but it's worth noting that the saving ratio appears to have stabilised after many years of perpetual decline. That might suggest that consumers have finally recognised that the equity boom is over. They are no longer quite so willing to go on a major spending spree because equity gains are no longer there to bail them out (see chart).

Elsewhere, the impact of falling equity prices on saving behaviour is less clear. Germans, for example, have never been big investors in the stock market, preferring the safety of bonds. Even in Germany, however, there are some signs that consumers have reacted adversely to falling share prices. Those Germans who did dip their toes into the water ended up in the shark-infested seas of new technology, where their savings were chewed up and spat out. The German effect is doubtless a lot smaller than in the US but it's worth noting that Germans have chosen to save, rather than spend, the tax cuts earlier this year.

There is a general point about all these shifts in financial wealth. Financial wealth – in the form of equities, bonds and cash – matters a lot more to people now than it did 60 or 70 years ago. Life expectancy is on the rise yet retirement ages have not gone up. As a result, people are recognising that they need to put more and more away for a very long rainy day.

What they ideally want is a savings vehicle that will do a lot of the work for them. Judged by the returns seen over the past 10 years, equities looked to be a very good bet. Yet, returns will ultimately be governed to a greater or lesser extent by the overall growth rate of the economy. If that hasn't changed very much, then the bull market of the past 10 years gives a very misleading impression of the underlying achievable rate of return. When reality ultimately sinks in, people will have to save more out of current income to invest in what may prove to be rather low returning assets. There is no such thing as a free lunch.

Meanwhile, on the human capital front, unemployment is likely to be the big story for 2002. For some countries, there will be hopes that the worst is now behind us. In the US, for example, the weekly jobless claim numbers have improved, suggesting a moderation in the pace of job loss over the past couple of months. Elsewhere, however, unemployment is likely to be the key determinant of the likely success of the policies pursued over the past 12 months. In the UK, for example, the biggest threat to economic stability at this stage is not the – remote – possibility of a rapid rise in base rates but, rather, the possibility of a savage further round of corporate lay-offs, forcing consumers on to the back foot and leaving retailers with a nasty hangover.

Animal spirits may be greater in the stock market than they are in the economy at large. It's fairly clear, however, that the advent of financial liberalisation has increased the reaction of the broader economy to the fickle moods and swings of the equity market. People plan, save and borrow on the basis of movements in share prices and, as a result, increasingly go from wild spending sprees into fits of depression. The boom in equity prices in the late 1990s, built on heady optimism, provided the funds for excessive spending on capital goods and consumer goods. The fall in equity prices over the past 18 months points to a completely different story. 2002 may be a better year for the global economy than 2001 but, like the viewers of Animal Hospital, we will be watching with baited breath to see if the patient is really capable of making a sustained recovery.