Economic View: Wall St tumble would not mean the end of the world

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The Independent Online
It is not a bad rule of thumb that, when experts agree, one should expect the reverse to happen. Never the less, the expectation is so general that it really does deserve to be taken seriously. The valuation of Wall Street on most measures is at the extreme top end of the scale. The Bank Credit Analyst valuation indicator, shown in the graph, is particularly worrying, but the BCA "fair value" indicator, shown below it, is also well out of line. Put at its lowest, there is a serious possibility that Wall Street will fall sharply before the year is out. The tremors of recent trading will then be seen as early warning of the main shock to come. So even if past experience suggests that the outcome will still surprise, the possibility of a sharp fall in share prices does at least seem serious enough for it to be worth proceeding to the next question: so what?

The central issue here is whether there is a clear linkage between what happens in financial markets and what happens in the real economy. One link is the cross-border one: does a fall on Wall Street lead to a world- wide crash? That, I think, can be quite easily answered by taking two reference points: the relative overvaluation of US markets vis-a-vis the others; and the experience of the recent past. As far as valuation is concerned US shares are indeed expensive on most valuations by comparison with European markets, but they are not absurdly out of line. They are high, but we are high, too. And the history of the last Wall Street crash, of October 1987, suggests a strong linkage with all large markets except Tokyo.

A common sense conclusion would therefore be that a fall on Wall Street would make a serious dent in European share prices, though the fall would not necessarily be a one-for-one relationship.

The other, and in many ways more important link, is between financial markets and the real economy. As the Economist pointed out at the weekend, the collapse of the Japanese stock market has proved a serious inhibition on the recovery there. But Japan, with its substantial cross-holdings between companies, the weakness of its bank balance sheets and its tiny dividend yields, really is different from North America and Europe.

In the US the experience of 1987 was that there was virtually no linkage between the financial markets and the real economy. This was not what was expected at the time, with the result that the crash encouraged policy- makers to cut interest rates (to offset the supposed deflationary impact of lower share prices) just at the point in the cycle when they should have been increasing them. This error increased the scale of the late 1980s speculative boom and hence the scale of the early 1990s recession. Have things changed since 1987?

There are several potential reasons why they might. In the US there has been a sharp rise in the proportion of personal wealth held in mutual funds, unit trusts in our parlance. Indeed the flow of savings into these has been one of the main motors between Wall Street's recent strength. Suppose, so the argument runs, these funds are regarded by the holders as something akin to bank balances (though in reality they are nothing of the sort), then were their value to fall US consumers would feel inhibited and cut back their spending. This would be a classic "wealth effect" as outlined in the economics textbooks, where a change in people's wealth, rather than their income, affects their spending.

This sort of wealth effect from a change in share prices would be less likely to occur here because share prices play a much smaller role in our direct savings. They are enormously important in indirect savings through life assurance and pensions, but we don not see the notional value of a pension to be claimed in, say, 20 years, as relevant to our current spending, and who can blame us. House prices are far more relevant.

Never the less, personal shareholdings have risen since the late 1980s as a result of the development of Peps, share bonus schemes and the continuing stream of privatisation issues. I think it would be reasonable to expect a sharp fall in shares prices to have some impact on current spending, though more through a perception of confidence in the country's economy rather than any direct influence though the share price movement itself.

Another link is through business confidence. Companies see their share price falling and might feel more concerned about the business climate in general, cut back output and so on. Again this is the sort of thing noted in textbooks, but here I suspect there is even less of a link. Look at the way in which the present share price boom has failed to boost business confidence: the main drivers of that seem to be order books: sustained, profitable, practical demand for the product. True, lower share prices make raising new equity capital more expensive, but the proportion of companies which would need to raise new capital at any one particular time would be limited. Most would wait until things looked up and meanwhile increase their bank borrowings.

Potentially more worrying is the possibility that the Japanese disease would manifest itself in Europe: because of cross-holdings of companies capital a share price fall affecting the solidity of the banking system. This would not happen in the US or the UK because banks are not long-term holders of industrial companies' shares, but it is possible on the Continent, particularly in Germany.

Conventional analysis comes up with a fairly bland conclusion. Yes, a share price collapse would, through the wealth effect, have some impact on demand in the US and to a lesser extent in Britain. But it would not be so dramatic that it could not be countered by a looser monetary policy.

I would go along with that don't-get-excited line were it not for three things. First, the US mutual fund link is important and new: we could see recession in the States, and if that happens it will surely spread here.

Second, the fall in share prices, if delayed into next year, could come at just the time when the next British government had to tighten policy to cut back consumer demand: the danger of the "triple whammy" of higher interest rates and higher taxes coupled with lower share prices all hitting the economy at just the wrong time. Remember, the US economy is at full capacity, with pressure on the labour market, as shown in the graphs on the right, and in any case faces higher interest rates. Higher interest rates there will help drag up rates here.

Finally, the share-owning culture may have taken more root here than we realise and a change in the spending habits of a small proportion of the fairly rich might trickle down. We like being gloomy; a share price crash would give us additional support for our inclinations.

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