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

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The Independent Online

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