Hamish McRae: It will take time, but we'll recover

If officialdom seems over-optimistic in its forecasts, the markets seem too pessimistic
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The Independent Online

Why do the financial markets remain so catastrophically gloomy when the world's governments and central banks are striving so hard to rescue the world economy? The governments, our own included, are piling money into the banking system and, in some cases, supporting large commercial companies too. The central banks, here as elsewhere, will carry on cutting official interest rates – there will be another cut tomorrow after the Bank of England's monetary committee meeting. Meanwhile budget deficits are soaring around the world, with our own version of this fiscal boost one of the most extreme.

Yet confidence refuses to return. Share markets have a few good days then, in a bad afternoon, lose all the ground they laboriously gained. House prices everywhere continue relentlessly to head downwards. And now there are growing signs that major companies are struggling to finance themselves, as banks either tighten the terms on which they will roll over their loans or refuse altogether. The sad string of redundancies here in the UK and elsewhere is the inevitable result of this mounting pressure.

So if the aim of governments was to restore confidence they have so far failed. That is the inescapable conclusion, one to which people react in one of three ways. One is to say the policies are wrong. Another is to say that the markets are wrong. And a third is to say that these things take time to work through and that eventually some sort of economic recovery will be sustained. Actually I think there is some merit in all three and each deserves attention.

Policies will never be perfect; we would not be where we are if that were so. The question really is whether they are good enough. So far the combined efforts of the various national governments and the International Monetary Fund have at least prevented a collapse of the world banking system, as in the 1930s. What has been done is really a scaled-up version of the string of national banking support programmes that have been used in the past, for example in Scandinavia in the early 1990s.

It has been huge and, notwithstanding the collapse of Lehman Brothers, has just about held things together. But it is not over yet and despite the recapitalisation of the banking system, the ability of banks to maintain their lending is limited. Here in Britain the supply of mortgages has shrunk because the lenders don't have the money to lend. So the central banks have to go on and on supporting the system.

So the monetary side of policy has been a partial success. What of the fiscal side?

Here we just don't know. Governments have only just begun to put together their programmes and it is far too early to know the results. We have had two days here of the cut in VAT and we won't know the effectiveness of that for several months at least. What we do know is that there will be a large burden on future taxpayers everywhere in order to try to check what is, on the official forecasts, still a pretty limited downturn. On the Treasury's forecast this recession will be both shorter and less deep than the early 1990s one. Yet our fiscal deficit is forecast to rise to 8 per cent of GDP, the largest gap since 1947, and that figure looks optimistic.

So you cannot say that fiscal policy has failed, here or elsewhere, because the downturn has only just begun but things don't look promising. At best we don't get much of a bang for our bucks; at worst we are wasting tens of billions on a policy that isn't going to help.

But if governments are not doing too well, nor are the markets. Share prices are implicitly saying that the world faces a more serious downturn than any of the post-war recessions, including the really nasty ones in the 1970s and 1980s. Anything is possible but that really doesn't seem probable. If the world of officialdom is overly optimistic, in its forecasts if not in its rhetoric, the world of the markets seems overly pessimistic.

There is one practical reason for that. It is that share prices have been artificially depressed because equity markets are liquid. There are buyers and there are sellers. There is a price for every share, albeit perhaps not a very good one. That does not apply to the assets of the hedge funds or private equity funds, still less to all the alphabet soup of derivatives. So investors that find themselves strapped for cash, perhaps because they have borrowed too much and the banks want their money back, have to sell the things that have a price. For many that means equities.

You could say that these professional investors should not have got themselves into such a mess but people in every walk of life, including politicians and journalists, make mistakes. Collectively the world of finance became far too optimistic; it had in the jargon far too large an appetite for risk. Now it has gone to the other extreme, becoming too risk-averse. And in a way, who can blame the markets? Investors who earlier this year helped to recapitalise the Royal Bank of Scotland and who now see their money worth only a quarter of what it was, do have a right to feel less appetite to step up to the plate next time.

So what will happen? Well I think these things simply take time. To take a very practical issue, it takes time for house prices to reach a level where people are confident they are fairly priced. If they were, say, 40 per cent above their long-term equilibrium level relative to earnings, and earnings go up by 3-4 per cent a year, then if they fall by 15 per cent for two years things are more or less back to balance.

As for the economy as a whole, you can look at past post-war recessions and use them as a template for what might happen this one. I have just been looking at that and if this downturn is an average one we will hit bottom next spring or summer, bounce along with nothing much happening for a year, and then see a solid recovery starting about the middle of 2010. But we won't be back to the peak level of GDP that we were at in the second quarter of this year until well into 2011. Since share market recoveries anticipate economic recoveries by six to nine months that would suggest that shares will not go anywhere until well into next year, maybe not until its end.

Unfortunately no downturn is exactly the same so that timetable sketched here should carry a capital letter health warning. But we can assert with some confidence that something like it is likely to occur and that by 2012 the recovery will be solid and secure.