Hamish McRae: Don't despair, for economies have a way of ultimately self-correcting

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The Independent Online

A couple of better days on the markets – so was that it, or was it yet another false bottom?

A couple of better days on the markets – so was that it, or was it yet another false bottom?

It is one of those times, after such a truly dreadful quarter on the markets, that people need to trust their own instincts, but be aware that everyone else will be distrustful. The experts have been wrong and for professionals in any walk of life it is troubling to be proved wrong. When you have also lost other people a great deal of money, it is doubly troubling. And if you are frightened you may lose your own job, as many fund managers have, it is triply troubling.

False bottoms – when a market seems to recover by 10 per cent or more from a bottom but then plunges to an even deeper low – are a reasonably common phenomenon. Often there are two such dips in a bear market. But this time, looking at the US market in particular, it seems there have been four such bottoms and if the last few days do not signal the absolute bottom of this cycle, then there will have been five (see first graph). As Don Straszheim, the independent economist based in Santa Monica, points out, this is very unusual.

So not only do we have a long and deep bear market but we also have one that has been destructive of investor confidence. It has been one of those unusual periods when buying on the dips has been the wrong policy.

This graph takes the US experience, but that is not a bad proxy for the world. If it has been a dreadful three months for US shares, it has been a worse one for all the other major markets, save Japan. There things are so bombed out that its fall of a further 11 per cent between 1 July and 30 September merely means that the market is at a 19-year low instead of a 17-year one. Indeed one of the interesting things about this market is the global scale of the collapse and the way that no one has escaped the mauling. And that is despite very different economic prospects for the main economies.

The second graph shows the newly revised Merrill Lynch forecasts for several of the larger developed countries this year and next. I prefer taking a commercial forecaster because the official ones always lag reality and frankly are often manipulated for political purposes. The consensus forecasts are better value but include some official forecasts and inevitably some out-of-date ones too.

Looking at those forecasts two things stand out. The first is the disparity of performance this year. Australia is doing wonderfully and Canada, the US and the UK are all fine. As a rule of thumb English-speaking countries have done vastly better than continental European ones, while the country with the poorest English-language skills, Japan, has done worst of all. I don't think you could quite argue from this that the path to economic success is to learn English but it is clear that something odd is happening. My own general interpretation would be that the market-based financial system in the English-speaking world is more robust in tough times than the bank-based one of continental Europe and Japan. But obviously there are many other factors.

The second thing is that next year will be materially better than this one. That is worth saying again. Next year will be materially better than this one. Amidst the many reasons for fussing about the shape of the recovery – maybe it will be profitless, maybe deflation will take hold, maybe there will be a double-dip this autumn – I have not found any economic forecast anywhere in the world that suggests that global growth next year will be worse than this. So there.

There is one powerful reason for supporting this reasonably positive view for growth: the scale of the monetary stimulus that the world's central banks are pumping into the economy. Yes, Japan's interest rates, close to zero, are ineffective because falling prices mean that zero is too high. Yes, the European Central Bank is maintaining rates that are probably half a per cent too high for the region (and 1 per cent too high for Germany). From a global point of view it is bad luck that one-third of the world economy should have chosen this time to create a new currency and have flawed institutional structures associated with it.

But look at the third graph, which looks at real monetary policy in the Organisation for Economic Co-operation and Development (OECD) area, weighted by GDP, over the past 20 years. By any recent historical standards monetary policy is very loose and the Merrill Lynch forecast is that it will stay loose through to 2004. Remember, these are real rates (ie allowing for inflation) not nominal ones. Pump in such very cheap money and if the economic relationships of the past mean anything at all, this must drive up demand. It is a no-brainer.

When will that view take hold in the markets? It is the task of financial markets to look through both gloom and cheer and spot the sunlit uplands – or the dark valleys – that lie beyond. Contrary to popular wisdom, they have not been too bad at that over the past couple of years. They started to flash red a couple of months into 2000 and turned down in the spring. We should have known that the absurdity of that party in the Dome was a classic "sell" signal. But the world economy raced on for more than another year. Now the markets ought to be signalling what should be in store for us at the back end of 2003. Or rather they ought to within the next three or four months because the scale of the despair now mirrors the scale of the euphoria of early 2000.

None of this says anything about the nature of the next bull market in equities as and when it comes; nor does it say much about the durability or pace of the recovery. It is conceivable that there will be yet another false bottom. But just as we should recognise that the bubble of the late 1990s was unusual in historical terms, so the scale of the market slump is pretty unusual too. If those economic forecasts for next year in the graph are anything like correct, financial markets will recognise that.

The curious thing is that much of the logic that drove the hi-tech boom is still valid. The enthusiasts were right; just a little ahead of their time. Better and cheaper telecommunications do make it possible to manufacture goods more efficiently and, more important because it is a bigger proportion of the economy, increase the productivity of the service industries too. But it takes time to figure out how to make the best use of all new technologies. We are into that learning period now, but without having the self-confidence to realise that rising productivity eventually drives economic growth. Sometimes it is easier to look two or three years ahead than one. The prizes for those who can do so are huge.

Finally it is worth remembering that economies are self-correcting. They can cope even with quite a bit of bad policy and still manage to move forward. Let's accept that the US Federal Reserve Board made a major policy error when it failed to curb the hi-tech bubble. Let's accept, too, that the ECB is making the opposite error now. But even with these errors we will get better growth next year.

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