Hamish McRae: On the road to recovery, a modest optimism points the way ahead

Economic View
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The Independent Online

A turning point at last? This week we should get confirmation in the GDP figures that the UK economy has bottomed out in the July-September quarter.

If there is any growth, and there ought to be a little, that will suggest the recession is over in the UK, at least in a technical sense. On the Continent, there seems to have been some growth, perhaps a little more than here, and that should be confirmed. In the US, we have to wait until the end of the month for official figures but the markets expect growth at an annual rate of between 3 and 4 per cent in the third quarter.

So the big picture for the developed world is that at worst the economies are stable and at best there is the prospect of reasonable growth in the months ahead. Among the emerging nations the picture is much more positive, with continuing rapid growth in the two largest economies, China and India. The figure that stunned me last week was one from India: industrial production in August was up 10.4 per cent, a 22-month high. Recession, what recession?

At any rate, the markets seem to have bought the positive story, notwithstanding the so-far muted nature of the recovery and the dependence on the strong fiscal and monetary measures put in place by the authorities. The major stock markets were at, or close to, yearly "highs" last week. Markets do try to anticipate economic conditions in the sense that while they cannot change what will happen to the economy, they give an early warning of turning points. And so it was in March that they concluded that this was not the 1930s and there would be an upturn – beginning a remarkable bull run.

So what happens next? If you ask people you get the usual range of opinions from optimists who argue that there is still some way to go, to pessimists who say get out now while the going is good. Divergent views are what make a market. To help pick through all this, I have been looking at work from Barclays Capital, which is towards the optimistic end of the scale, but has been diligent in acknowledging the concerns of the sceptics. It has been looking particularly at US data, but the arguments apply here and on the Continent too.

From August 2008 through to February this year there was a profound and deepening gloom. Everyone wanted to play safe and dumped anything that appeared to be risky, including equities which were at least tradeable. Since US Treasury securities were deemed the safest assets of all, money went into those. The dollar was strong and the yield on 10-year treasuries was driven down to almost 2 per cent during the worst moment back in October last year. Share prices continued to fall until March. Barclays sees this period as one of risk aversion, with the aversion overshooting. Then this year the willingness of investors to take on risk gradually recovered. Share prices rose, as did the yield on treasuries. People who bought treasuries yielding 2 per cent and sold them six months later will have lost a huge amount of money: safe is a relative concept.

That period continued through to about June this year, then something strange happened. Share prices went on climbing but the yield on treasuries did not. Why so? Well Barclays' explanation is that quantitative easing worldwide took over. Money was being pumped in by the Federal Reserve, the European Central Bank, the Bank of England and other central banks and this enabled shares to go on rising and governments to finance their deficits without being forced to pay more in interest rates. You can see the three periods in the chart.

This makes sense as an explanation, but what are the implications for the future? Several points. The first is that shares are no longer cheap. They are around "fair value" on various conventional measures. Clearly a couple of years ago they were too expensive; in the spring they were too cheap. But trying to be precise about what constitutes "fair" does not get us anywhere. Barclays' point is that if you want to justify further increases in shares you have to postulate that profits will improve more than expected over the next year. It is relatively positive about growth so it feels one can justify another 10-15 per cent on share prices.

But quantitative easing will end; it has to. As it tapers off, Barclays expects long-yields to rise. Put another way, when governments have to rely on genuine savings to finance deficits, they will have to pay higher interest rates to attract the cash. But that will surely be done gradually, and short-term interest rates will stay low for a while yet. Assuming the exit from quantitative easing is managed carefully and inflationary forces remain muted, the exit should not be catastrophic – it is in no one's interest for that to happen.

My own feeling is that this modestly optimistic perspective is about right. Policy has worked. It may not have been optimal but it has been good enough. The issues now will be how to get back to normal and how to cope with the nasty surprises that will inevitably hit us in the months ahead.

The important thing to remember is that under normal circumstances, economies are self-healing. We have had abnormal circumstances which have required an abnormal response. So now the key thing is to set out a path back to normal fiscal deficits and normal monetary policy. By that I don't mean every government and central bank should publish its plans for reducing deficits and increasing interest rates. That would be absurd and no one would believe them anyway. But it would be helpful to have broad ideals described so that financial markets can feel secure enough to support the self-healing process.

As banks have retreated, the securities markets have taken over. Companies have been relying on bond issues to finance themselves rather than syndicated bank loans, reverting to 1960s-style (or even 1890s-style) funding. That will continue. We are in one of those long-term cycles when one form of finance gains importance vis-à-vis another. There is nothing wrong with that, except that the more the banks shade back, the greater the burden on the capital markets. The sheer amount of funds that have to be raised will hold prices back.

The best way to put into context the recovery in share prices is not to say – ah, this is all the result of the money being pumped in by the central banks and they are creating another bubble. It is to say that, thanks to exceptional measures, markets are functioning in a reasonable way. The economy is not back to normal – that will take another couple of years at least, and there will be bumps on the way. But a precondition for a sustainable economy is sustainable finance and the first steps along that path have been taken.

It's time to remember Smith's warning about society and the market

If, by finding their nerve, the markets have begun to support the recovery instead of undermining it, they will nevertheless remain under suspicion for the foreseeable future. So a new book from the economist Roger Bootle, The Trouble with Markets, is aptly titled. Bootle's book deserves attention because he has been broadly right about this cycle: he warned of the dangers of the asset bubble and the likelihood of the downturn being much more serious than forecasters predicted, but equally he was not one of the "depressionists".

His thesis is that, while the crisis has a number of causes, the thing that pulled them together was an excessive belief that markets were always right and could be left to their own devices. He goes through the causes and consequences and that is most helpful, but the aspect of the book that will attract most attention will be the part that deals with how we dig ourselves out of the mess. He sets out four pillars: rebuild the banking system; boost income and wealth; stabilise public finances; and rebuild confidence.

That must be right but where Bootle is helpful is in his tone of moderation. Yes, there should be a fiscal boost to demand but this has to be within reasonable limits and public finances gradually brought back under control. Some countries need to correct their deficits more urgently than others: the UK for example faces significant fiscal tightening. There will inevitably, and properly, be greater curbs on markets in general and on financial services in particular. But he is not, as he stresses, "anti-market".

"The trouble with markets," he writes, "is that some of them work better than others. When all are left to their own devices, the interaction of the ones that do work well with those that don't produces a dog's breakfast."

Or as Adam Smith noted in The Theory of Moral Sentiments a society needs mutual trust and well-functioning institutions as well as the market mechanism. Funny, is it not, that we have to keep relearning such basic rules?