Hamish McRae: We need some retail therapy

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The Independent Online

It was one of those weeks, wasn't it? Trouble is, in the financial markets, there seem to be a lot of those weeks coming along.

It was one of those weeks, wasn't it? Trouble is, in the financial markets, there seem to be a lot of those weeks coming along.

Yet, yet, yet – look around and you don't feel any catastrophe in the real world, certainly not in the UK. Unemployment remains low, retail sales high, inflation low, house prices high. This raises a fundamental question: what threat does the mayhem in the financial markets pose for the real economy? Or, put another way, might the destruction of wealth in the markets make us less confident consumers and so undermine the recovery?

By coincidence, the Bank of England's Financial Stability Review came out on Thursday, the day after the revelations at WorldCom hit the markets. Every six months the Bank gauges the risks to the world from financial pressures, and its message this time was reasonably reassuring. It pointed out that we have had the world's largest country default (Argentina) and the world's largest corporate bankruptcy (Enron) but the financial system has proved resilient. The improvement in the world economic outlook since December ought to benefit the system, but it added: "The accounting, transparency and governance issues raised by Enron and some other cases may have clouded market perceptions of corporate prospects..."

I like that "may have clouded market perceptions", because the people in the markets who are running around warning of another 1929 are the same people who allowed the telecoms bubble to build – and burst. They had clouded market perceptions then and they have 'em now.

Accountancy, transparency and governance are relative terms. There are no such things as perfect accounts, total transparency or optimal governance. They just have to be good enough. One of the intriguing developments this year is that the part of the world that raised most concerns on these issues four or five years ago now seems in the clear.

The left-hand chart above, taken from the Bank's review, shows how markets just about everywhere have had a dreadful six months. But look at the place where they are sharply up: emerging markets. Remember the East Asian "crony capitalism" crisis? We couldn't trust the accounts of these companies, nor the currencies of the countries where they were based. Now that is all forgotten. Indeed, one of the most unfair aspects of that crisis, where good and bad companies were lumped together and suffered equally, is not evident now. Thus confidence in emerging markets has improved despite the plight of Argentina.

This reflects economic performance. In East Asia in particular there has been a clear bounce in production this year. That region is growing again, leading the rest of the world, and so it is encouraging that markets recognise this and mark up the shares.

If growth is sustained in the developed world through the autumn, it seems at least a reasonable supposition that markets elsewhere will recover their poise. This leads to the "will consumers keep cheerful?" issue.

Detailed work on the relationship between personal wealth and consumer spen- ding has been done by the International Monetary Fund and was published in its spring World Economic Outlook. The other two graphs are taken from this, one showing the relationship between wealth and savings (for the US and UK), the other between net wealth and stock market prices.

The centre graph shows that in the US there seems a very clear 30-year trend for people to save less as they become richer. Americans now hardly save at all. But that trend is not so evident in the UK. We too have become richer – in fact, relative to income we are richer than Americans – but we are still saving, albeit at the bottom of our 30-year range.

So if wealth falls, as it has after the decline in share prices, will people save more and spend less? Looking at the graph I don't think Americans can be expected to change their habits much. The fall in savings is a long-term trend that has endured through the economic cycle. If it is going to reverse, it will be because even Americans will get a bit worried about not saving at all, or because of another long-term social change.

Here it is a bit different. We did cut our savings in the early Eighties as we became richer, and then rebuilt them in the late Eighties and early Nineties when our net wealth fell. But remember, the mid-Eighties were the years of the extreme housing boom, and the early Nineties the years of negative equity. Maybe the importance of house prices influences our savings patterns.

That would seem to be supported by the evidence of the right-hand graph. The rise of US wealth has been largely dependent on share prices, whereas here, housing is more important.

A couple of very tentative conclusions would seem to stem from this, one for the US, one for the UK.

In the US, there will be no sudden shift in savings (and hence spending) habits, but there will be a somewhat depressing impact from share prices if these market declines are not recouped fairly soon. Americans will eventually rebuild their savings, but probably only a bit and not swiftly enough to undermine consumption.

Here, since we are at the bottom of our saving range, at some stage we too will increase our savings a bit. But house prices will determine what we do. Provided they stay reasonably strong, we are unlikely to cut back spending hard.

If these conclusions are right – and, of course, a general crisis in confidence could render them too optimistic – then a slowish recovery should still happen in the US and we should keep growing here. The destruction of wealth that has taken place on the markets is not serious enough to undermine things in the US. And the UK economy will be fine provided house prices plateau rather than plunge. But keep your fingers crossed.

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