Hamish McRae: It was better for the market froth to be blown away sooner rather than later

Experience of financial crises shows that the cost of not supporting major institutions is greater than the costs of doing so
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The Independent Online

It may be rather an unfashionable thought but I am wondering whether the fact that the storm should have broken this summer - rather than some time next year - will mean that its overall impact will turn out to be much more manageable than many of us feared.

The argument goes like this. Try it and see what you think.

For at least nine months it has been clear that the global boom would need to be curbed. That is why interest rates have been going up around the world. It was also clear that parts of the United States property market were in trouble. I recall going to the Detroit region last autumn and noting the awful condition of the market there. And long before the sub-prime bubble burst many commentators noted that the terms on which money was being lent in the US were ridiculously lax. Interest-only mortgages are one thing; mortgages where the interest itself was piled on to the loan and only repaid on maturity are something else.

Nevertheless, through the spring and early summer the markets' appetite for risk grew. Share prices soared on most major markets, with the UK a bit of a laggard, especially when compared with places such as Shanghai. More important, the markets for synthetic debt (bundled-together bits of other debt so complex that not even the regulators understood where the risks lay) grew hugely in size.

Now, in the space of less than three weeks, all the froth has been blown away. Central banks have had to pump funds into the money markets, as they always must when the banking system is threatened by a liquidity crisis, and there is talk of interest rate cuts.

We will see about that. You have to realise that we are probably still in the quite early stages of this bout of market turmoil. though it is impossible to know for sure until long after the event. The classic signal of a turning point is for a major financial institution somewhere in the world to need to be rescued. Long experience of financial crises shows that the costs of not supporting major institutions is much greater than the costs of doing so.

But think what it would be like had there not been this serious bout of the jitters. Share markets would be sizzling upwards, banks would be dreaming up ever more complicated formulae for trading, hedge funds would be borrowing more and more to fund bids for dodgy assets. As a result the pressure for higher interest rates would keep increasing.

It would have been much better had the great wall of money that has been washing round the world for the past five or so years not been created. The blame for that must be shared by the US Federal Reserve and the Japanese and Chinese monetary authorities. Together they created the conditions for a global asset bubble. But at least that bubble has been pricked, and pricked rather earlier in the economic cycle than the dotcom bubble of the late 1990s.

If that all sounds quite encouraging, what happens next?

The core issue is whether financial market disruption damages global economic growth. The first graph shows the OECD leading indicator and the Merrill Lynch fund manager survey. The two fit pretty well until last year, when the global outlook remained positive while the US one went negative. Merrill Lynch's assessment of this is that this bout of trouble is not the "big one" and that Asian growth can continue despite a slowdown in the US.

It would follow that monetary policy outside the US, and particularly in Asia, will go on tightening notwithstanding what the Fed does or does not do.

If that is right, the answer is that the financial market disruption will have some impact on global growth but (a) growth had to slow a bit anyway, and (b) Asian growth can continue to be strong despite the US slowdown.

From a UK perspective it is too early to expect any easing of policy, partly because our own growth is not threatened, at least for the time being, and the underlying inflationary pressures remain strong. The second graph shows the relationship between broad money growth, advanced six months, and the consumer price index.

As you can see until a couple of months ago the two have fitted astoundingly well for a decade. Monetary growth remains high despite the rise in rates, which suggests either that something radical has changed or that the recent cut in the CPI (which is an unsatisfactory index anyway) will not be sustained. My guess is the latter. Capital Economics, which fitted the two series together on that graph, thinks that there will be renewed upward pressure on the CPI in the coming months. Yesterday's monthly trends from the CBI confirm that both demand and price pressures remain strong.

That in turn suggests that there may still be rises in rates out there in the future, though I would expect the conditions of the past couple of weeks to delay the next increase by a couple of months.

The final two graphs, from Credit Suisse, explore the relationship between share prices on the one hand, and consumer spending and business investment on the other. There is not much of a relationship between the first two. In fact a fall in share prices may be associated with an increase in consumption, not a decline, if the share price fall is associated with lower rates. However there is some relationship with lower business investment.

That would figure. When share prices take a hit you would expect companies to question their investment plans, but with quite a long time-lag. Share prices are of course reflecting global economic conditions, and if those deteriorate you would expect investment cutbacks. Overall, Credit Suisse concluded that a 10 per cent fall in share prices would eventually be associated with a 2.5 per cent fall in consumer spending and a 7.5 per cent fall in investment. But over a long period, and we have only had a few weeks of weak share prices, surely not long enough to have much impact.

My instinct here is that the market turmoil is fundamentally welcome because it will reduce the need for much higher interest rates. In other words, a global boom that was in danger of getting out of control has been curbed without the need for as high rates as would have otherwise have occurred. As a result, the forthcoming cyclical global downturn will be more benign than we might have expected a month ago.

None of that should be taken to mean that shares will this year recover all the ground they have lost in the past three weeks. We may still end up with a year when the main markets end down rather than up. Nor does it mean that all the underlying weaknesses of the global economy, including the US's reliance on capital inflows to cover its current account deficit, have gone away. My point is simply that the current caution is fundamentally more healthy than the euphoria of a month ago... even if both have been a bit overdone.

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