Diane Coyle: Strife in the markets doesn't always mean there's going to be a slump

'There is every reason for caution, but the manic depression should be left to the financial markets'
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The Independent Online

The world's stock markets are starting to look as if they are in free fall. Is it not time to announce a fully-fledged financial crisis? And if shares in New York and London keep falling like this, surely recession is inevitable? Well, "no" and "no" are, in fact, the right answers to those questions.

The world's stock markets are starting to look as if they are in free fall. Is it not time to announce a fully-fledged financial crisis? And if shares in New York and London keep falling like this, surely recession is inevitable? Well, "no" and "no" are, in fact, the right answers to those questions.

It is easy to see why the financial pundits have become very gloomy. They have been sitting in front of screens lit red by falling share prices for day after day now. In the US the Nasdaq index, composed of high-technology shares, has lost more than two-thirds of its value in 12 months. The darlings of the dot.com stock-market bubble on both sides of the Atlantic, like our own lastminute.com, are now worth perhaps 10 per cent of their peak market value.

The decline in share prices, which until last week had only affected technology, media and telecommunications companies, has now spread decisively to "old economy" businesses. The euphoria about the "new economy", that nirvana of high productivity and growth fuelled by information and communications technologies, has utterly evaporated.

Ever since the bubble started inflating in late 1996, however, many commentators have been arguing that the stock market was over-valued. Not surprisingly, those who were most sceptical about the new technologies from the start are now the most eager to pronounce the entire episode finished - and the most convinced that a recession is around the corner as the US economy goes through an inevitable retrenchment from its financial excess.

Well, perhaps they will be proved right. It is impossible to know what the long-term effects of any new technology will be; even Bill Gates once wasn't interested in the internet. Nor can there be great confidence yet about whether there has been a permanent improvement in productivity trends - in fact, how well companies sustain productivity during the next downturn will be one of the key tests.

The doom-saying is premature, even so. One reason is that stock-market bubbles are very useful for spreading new technologies. While being able to raise capital at almost no cost does encourage over-investment in some projects that are not really viable, it is also true that, after the bubble bursts and lots of those shares are worthless, the technical advances and new products are still there.

The building of the world's rail network in the 1840s was financed by a speculative frenzy. The same thing happened in the 1920s with electricity, then with cars and radio. The legacy of the dot.com bubble will be the infrastructure of a fibre-optic cable network and the internet, new mobile devices, new software, new biotechnology products. The market frenzy was the froth on top of real and lasting advances.

There are very good grounds for believing that companies, even those in the US, have only realised a tiny fraction of the potential gains to be had from new technologies.

A new way of shopping was never going to transform the economy. Rather, computers and the internet will benefit the economy by allowing companies to alter the way they do business. Just as electricity did not boost productivity and growth until manufacturers built new plants with assembly lines to exploit the new power source more efficiently, today's new technologies will fulfil their promise when companies have transformed their supply chain and delivery logistics. Some have, but many have not, and they will need to do so to stay in business, short-term recession or not.

Second, it is always worth pointing out, when the prospect of a stock-market crash starts getting everyone very excited, that financial markets crash a lot more often than economies plunge into recession.

It took share prices a year to recover after the crash of October 1987, but the economy boomed on both sides of the Atlantic in the late 1980s. The bond market - less visible than the stock market, but no less important for the economy - crashed in February 1994. That slowed the pace of growth, but it did no more than that.

Then the financial crisis of 1997-98 actually turned out to be a blessing in disguise in the US and the UK, because it cooled down an economic boom that appeared to be getting over-heated. The impact of financial crisis on the state of the economy depends upon the circumstances - and on how the policy-makers respond.

Bringing interest rates down is the right reaction. The cost of loans in America has fallen by one and a half percentage points in 11 weeks. The Bank of England has cut rates and is expected to do so again, and now the European Central Bank has hinted that it will do the same. The Bank of Japan has cut rates to zero. George Bush is helping out with a big tax cut, and Gordon Brown by boosting public spending on health and education.

The US economy has one very big problem that lower taxes and interest rates will not solve, and that is the fact that consumers have been on a massive, debt-fuelled spending spree. The booming stock market made investors rich, and shares that kept going up in value made saving seem unnecessary.

Even with more money appearing in pay packets, the fact that shares are going down and down instead of up and up will lead Americans to stop buying new cars and computers and pay off some of their debts instead.

Britain went through the same kind of retrenchment in the early 1990s, after the credit-fuelled Lawson boom. This time, however, the British economy really is in quite good shape. It is hard to see the same kind of loss of confidence and belt-tightening going on here, when mortgage payments are falling and there are plenty of new jobs being created in the public sector, even if the private companies stop hiring until they see calmer waters ahead.

So there is every reason for caution, not least because a plummeting stock market will undermine business and consumer confidence, but the manic depression should be left to the financial markets.

d.coyle@independent.co.uk

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