Why a small blip in US producer prices set off a violent reaction on Wall Street

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Shaping events into simple stories is something human beings always do to try to make sense of a complex world. Unfortunately, today's two dominant economic parables are contradictory, and have different consequences for asset prices and growth.

Shaping events into simple stories is something human beings always do to try to make sense of a complex world. Unfortunately, today's two dominant economic parables are contradictory, and have different consequences for asset prices and growth.

The one that holds sway just at the moment is a tale of a decrepit old business cycle nearing its end. Both the United States and the UK have enjoyed unusually long expansions - 31 quarters of uninterrupted and rapid growth in the former, 28 quarters of uninspiring growth in the latter. In both cases unemployment has fallen lower than any economist would have predicted it could without triggering inflationary pressures. But although strong currencies have helped keep inflation very low, both economies are at last showing faint but unmistakable signs of a pick-up at the far end of the inflation pipeline.

This is why the financial markets have grown so nervy about the prospect of interest rate rises on both sides of the Atlantic. Although no one really expects more than a quarter percentage point increase next month, and perhaps one point altogether, the move will look like the last rites for the longest post-war expansion in each country.

This is not to say that growth is grinding to a halt - far from it. The US economy is still growing at an annual rate of around 4 per cent, and UK growth is accelerating after last winter's pause. Even so, the business cycle has passed its prime of strong growth and low inflation, and moved into the late-cycle phase of continuing growth with rising inflation. In the past that has been followed by high inflation and slow or falling growth, thanks to too late a policy reaction, but tough and independent central banks might turn out to have changed that part of the story.

This narrative explains the violent reaction on Wall Street to what is, on the face of it, a small blip in US producer prices and the prospect of a modest rise in interest rates. But, of course, the reason the stock market has so far to fall in the first place is because there is a competing interpretation of the economy.

It is the "new paradigm". This attributes low inflation and strong growth to advances in technology and increased competition magnified by the Internet, to higher productivity and enhanced entrepreneurship. These are cited in explanation of the length of the expansion and the fact that unemployment has been able to fall so far while earnings growth has barely nudged higher.

None of these factors has changed. So in the tale of the new paradigm there is nothing worrying in the prospect of a small increase in interest rates to keep everything on track. Those who believe this account are the ones who see a correction in stock prices as an opportunity to snap up some bargains.

To say that both accounts can be true - that the economy's trend has improved because of the new paradigm but that the cycle has not thereby been abolished - is deeply unhelpful, at least for investors. Superimposing a milder cycle on a better trend might say something - and something good - about share prices in the long-run but not in the next six months or year.

Luckily, it is possible to say much more about an economy generally overlooked in most discussions of the two competing parables. Euroland is not only further behind in the business cycle, it also has a long way to catch up in the new paradigm.

It will take many more months of growth before there is a real need to worry about the Euro economy running into the inflation buffers. This has not stopped some members of the European Central Bank's Council from commenting about signs of inflationary pressure and hinting that interest rates will need to rise. But actually, those signs are metaphysical - rapid EU 11 monetary growth has no operational meaning just 10 months into the single currency. What's more, the ECB's pattern so far has been to match awe-inspiringly daft and unhelpful rhetoric with rather sensible policies. It should be able to resist its own pressure to raise interest rates some time soon.

More interestingly, there are now signs that the Continental European economies are quietly - even covertly - taking on some new paradigm characteristics. A new circular from Salomon Smith Barney points out that in the past half year the Euro area has seen its first net private sector jobs growth for more than three decades, apart from the temporary bulge linked to German unification. And, in a classic new economy signal, the cost of telephone calls has fallen sharply in most EU countries.

Europe also comes rather well out of a new publication from the Organisation for Economic Co-operation and Development, documenting the "knowledge-based" economy. It reports, for example, that the growth in EU investment in "knowledge", which includes investment in software, education and research and development, has amounted to 2.9 per cent a year from 1985-95, virtually the same as in the US. The rate of growth of venture capital in half of the EU economies has exceeded the US rate in 1995-97, although vastly more of the vastly greater amount of American venture capital is directed towards information technology and other high-technology businesses.

While it is certainly true that political and regulatory structures in the US have made it possible for businesses and consumers to put the new paradigm into practice, there are some signs that Europe is on the verge of taking the same route. In France, in particular, the public debate sounds as dirigiste as ever to Anglo-Saxon ears. Yet its jobs market is becoming more flexible and its finance minister, Dominique Strass-Kahn, is an effective reformer who this summer opted to announce a large cut in taxes rather than increase public spending.

If the new paradigm story has not got past its opening paragraphs on the Continent, and the tale of its business cycle is far from drawing to a close, then Euroland's prospects look rather different from those in the Anglo-Saxon countries. Better still, for anybody trying to make sense of a confusing world, both point to the same, upbeat outlook.

d.coyle@independent.co.uk

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