Stephen King: Markets are driven by a future view – and now reality is starting to bear on it


Economic Outlook Never assume August is going to be a quiet month. In the first week, we seemed to be on the verge of a financial apocalypse.

With an S&P downgrade and an Italian crisis, both the US and the eurozone were in big trouble – as, indeed, were the streets of London. By the end of the second week, we'd stepped back from the precipice. Policymakers had offered a bit of help. The Federal Reserve had promised to keep short-term interest rates at zero until 2013 at the earliest. Four countries in Europe had banned short-selling. Stock markets staged a bit of a rally. David Cameron came back from holiday.

Yet despite this more positive tone, investors are still nursing their wounds. While the freefall may be over – at least for the time being – the cuts and bruises are still there. The US stock market – measured by the S&P 500 – is down almost 10 per cent since the end of July. Other stock markets haven't done any better.

Why are investors in such a nervous state of mind?

With politicians on holiday or in total disagreement, it's easy enough to argue that the appropriate "fixes" have not been applied. Republicans and Democrats may agree on the need for deficit reduction but they cannot agree on how, precisely, it should be done. European leaders may agree on the need to resolve the eurozone crisis but they cannot agree on whether the burden should fall on Italian debtors or German taxpayers. In the absence of any agreement, investors simply feel the worst and markets collapse.

All of this is true. But it is not the complete picture. Quite simply, policymakers are running out of ammunition. In the early stages of the financial crisis – in 2007 and 2008 – interest rates were still relatively high and budget deficits quite small. Then things changed.

The key US policy rate – Fed funds – stood at 5.25 per cent in July 2007. By the end of 2008, it was down at zero. The Bank of England's key policy rate took a little longer to fall but it was, ultimately, the same story. Meanwhile, budget deficits running along at 2-3 per cent of GDP in 2007 suddenly went through the roof, heading rapidly into double digits.

These stimulus measures were one-offs. They cannot be repeated. Interest rates can't drop to minus 5 per cent. Budget deficits cannot expand to 18 per cent of GDP. There is no more ammunition, at least not of the conventional variety.

The authorities are running out of ammo

Moreover, the evidence increasingly suggests the salvoes fired in the early years of the financial crisis may have missed their target.

Events at the beginning of August were frightening because investors rightly recognised both that the time for bailouts and extraordinary stimulus measures had long since passed and also that those original measures perhaps hadn't worked took well.

Policy is supposed to work partly through its effect on expectations. In 2009 and 2010, things seemed to be going according to plan. Stock markets rallied, egged on by a combination of low interest rates and, later, the willingness of central banks to pursue so-called "quantitative easing".

With short-term interest rates at zero, turning on the printing presses seemed like a good idea. With all this extra liquidity, the hope was that asset values in general would rebound allowing companies to raise funds in the capital markets even if banking systems were generally comatose.

Such was the initial confidence in these measures that investors began to believe economic conditions were heading back to "normal".

At the beginning of 2010, they persuaded themselves that, having secured a decent economic recovery, the Fed would be raising interest rates by the end of the year. That didn't quite pan out. Their confidence undimmed, they then said that interest rates would rise by the end of 2011.

Now, however, the Fed is promising to keep interest rates low all the way through to 2013. The reason is, by now, obvious. The US economic recovery has been profoundly disappointing. The optimism on Wall Street simply did not transfer to Main Street.

Is the US Fed's decision good news?

Not really. A healthy, thriving, economy should have interest rates up at 4 or 5 per cent, reflecting a mixture of sustained economic expansion and a low, but positive, rate of inflation. If interest rates are stuck at zero, the economy is probably neither healthy nor thriving. Think, for example, of Japan, a nation stuck with zero interest rates for a big chunk of the last two decades.

And an economy stuck in a rut cannot provide the income gains necessary to allow debt to be repaid in relatively pain-free fashion. Governments borrowed heavily fully expecting their fiscal measures to lead to some kind of economic bounce back.

But as officials on either side of the Atlantic reduce their projections of future economic growth, so they're being forced to admit that fiscal positions are not quite so healthy after all. Large deficits, in turn, create uncertainty about future tax levels and spending commitments. That uncertainty leads to household restraint and corporate caution, thus negating the positive effect stemming from the original bout of fiscal stimulus.

So what would Maynard Keynes do?

Keynesians would doubtless argue that the mistake has been to threaten withdrawal of stimulus before the measures have had a chance to have their proper effect.

The loss of confidence has thus been associated with a shift in the political mood. The assumption seems to be that, with enough stimulus, an economy can return to the path it was on pre-crisis. Yet all the evidence suggests that periods of unsustainable financial boom are followed by prolonged periods of painful adjustment.

Stimulus might prevent the most apocalyptic outcome but it cannot take us back to "business as usual".

How long can we carry on like this?



If the new reality is a sustained period of weak growth at a level of economic activity far lower than was expected pre-crisis, it's no great surprise that financial markets have the occasional lurch downwards.

Financial assets are priced according to expectations about the future. As those expectations evolve, so stock and bond markets go up and down. With investors belatedly recognising that there is no prospect of a return to business as usual, financial assets are coming under tremendous strain, both because future income is lower and because the ability to repay the debts of the past is no longer there. Sometimes, reality bites.

Stephen King is the global chief economist at HSBC

Start your day with The Independent, sign up for daily news emails
Arts and Entertainment
Attenborough with the primates
tvWhy BBC producers didn't want to broadcast Sir David Attenborough's famed Rwandan encounter
News
people
News
Campbell: ‘Sometimes you have to be economical with the truth’
newsFormer spin doctor says MPs should study tactics of leading sports figures like José Mourinho
News
news
ebooks
ebooksA special investigation by Andy McSmith
Voices
Lance Corporal Joshua Leakey VC
voicesBeware of imitations, but the words of the soldier awarded the Victoria Cross were the real thing, says DJ Taylor
Life and Style
Alexander McQueen's AW 2009/10 collection during Paris Fashion Week
fashionMeet the collaborators who helped create the late designer’s notorious spectacles
Sport
football
News
i100
News
Perry says: 'Psychiatrists give help because they need help. You would not be working in mental health if you didn't have a curiosity about how the mind works.'
people
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

SThree: HR Benefits Manager

£40000 - £50000 per annum + pro rata: SThree: SThree Group have been well esta...

Recruitment Genius: Office Manager / Financial Services

£30000 - £37000 per annum: Recruitment Genius: Established in 1999, a highly r...

Jemma Gent: Year End Accountant

£250-£300 Day Rate: Jemma Gent: Are you a qualified accountant with strong exp...

Jemma Gent: Management Accountant

£230 - £260 Day Rate: Jemma Gent: Do you want to stamp your footprint in histo...

Day In a Page

War with Isis: Fears that the looming battle for Mosul will unleash 'a million refugees'

The battle for Mosul will unleash 'a million refugees'

Aid agencies prepare for vast exodus following planned Iraqi offensive against the Isis-held city, reports Patrick Cockburn
Yvette Cooper: We can't lose the election. There's too much on the line

Yvette Cooper: We can't lose the election. There's too much on the line

The shadow Home Secretary on fighting radical Islam, protecting children, and why anyone in Labour who's thinking beyond May must 'sort themselves out'
A bad week for the Greens: Leader Natalie Bennett's 'car crash' radio interview is followed by Brighton council's failure to set a budget due to infighting

It's not easy being Green

After a bad week in which its leader had a public meltdown and its only city council couldn't agree on a budget vote, what next for the alternative party? It's over to Caroline Lucas to find out
Gorillas nearly missed: BBC producers didn't want to broadcast Sir David Attenborough's famed Rwandan encounter

Gorillas nearly missed

BBC producers didn't want to broadcast Sir David Attenborough's famed Rwandan encounter
Downton Abbey effect sees impoverished Italian nobles inspired to open their doors to paying guests for up to €650 a night

The Downton Abbey effect

Impoverished Italian nobles are opening their doors to paying guests, inspired by the TV drama
China's wild panda numbers have increased by 17% since 2003, new census reveals

China's wild panda numbers on the up

New census reveals 17% since 2003
Barbara Woodward: Britain's first female ambassador to China intends to forge strong links with the growing economic superpower

Our woman in Beijing builds a new relationship

Britain's first female ambassador to China intends to forge strong links with growing economic power
Courage is rare. True humility is even rarer. But the only British soldier to be awarded the Victoria Cross in Afghanistan has both

Courage is rare. True humility is even rarer

Beware of imitations, but the words of the soldier awarded the Victoria Cross were the real thing, says DJ Taylor
Alexander McQueen: The catwalk was a stage for the designer's astonishing and troubling vision

Alexander McQueen's astonishing vision

Ahead of a major retrospective, Alexander Fury talks to the collaborators who helped create the late designer's notorious spectacle
New BBC series savours half a century of food in Britain, from Vesta curries to nouvelle cuisine

Dinner through the decades

A new BBC series challenged Brandon Robshaw and his family to eat their way from the 1950s to the 1990s
Philippa Perry interview: The psychotherapist on McDonald's, fancy specs and meeting Grayson Perry on an evening course

Philippa Perry interview

The psychotherapist on McDonald's, fancy specs and meeting Grayson Perry on an evening course
Bill Granger recipes: Our chef recreates the exoticism of the Indonesian stir-fry

Bill Granger's Indonesian stir-fry recipes

Our chef was inspired by the south-east Asian cuisine he encountered as a teenager
Chelsea vs Tottenham: Harry Kane was at Wembley to see Spurs beat the Blues and win the Capital One Cup - now he's their great hope

Harry Kane interview

The striker was at Wembley to see Spurs beat the Blues and win the Capital One Cup - now he's their great hope
The Last Word: For the good of the game: why on earth don’t we leave Fifa?

Michael Calvin's Last Word

For the good of the game: why on earth don’t we leave Fifa?
HIV pill: Scientists hail discovery of 'game-changer' that cuts the risk of infection among gay men by 86%

Scientists hail daily pill that protects against HIV infection

Breakthrough in battle against global scourge – but will the NHS pay for it?