Hamish McRae: Prepare for a slowdown, but not a crash

The end of the global property boom is in sight, and there will not be another for a long time
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The Independent Online

August has proved a wicked month and not just for the weather. Big storms take a while to gather strength and financial storms are no exception. But just as once a storm finally breaks people feel a certain sense of relief; the oppressive sensation of build-up disappears and at least we know that all storms blow themselves out in the end.

And so it is with the financial markets at present. We are still in the early stages of what will, I expect, be more weeks of rough conditions. There will be more serious casualties, not just some hedge funds which lose their investors a lot of money. If the present storm follows the normal pattern a major financial institution somewhere in the world will have to be rescued by the central banks - that usually being the signal for things to return to normal. But at least the problems of the financial markets are coming out in the open and that is encouraging in itself.

More encouraging is the reasonable probability that the market turmoil will slow down the world economy but not by enough to tip it into recession. The world economy is running hot at the moment, with signs of strain ranging from the high price of basic commodities such as oil and food, to more exotic measures of strong demand such as the number of advertising pages in the American edition of Vogue magazine. (There are 727 ad pages in the September edition, a record.)

Something had to check this. Something had to check the global boom in house prices. Until a few weeks ago it seemed clear that that something would be higher interest rates. In the US rates seemed to have gone up by enough to cap the property market. While in some areas house prices were still rising solidly, in others they were falling.

But rates were not, so it seemed, high enough to curb the animal spirits of the financial markets, which kept hitting new records. There was still a huge wave of liquidity - money or at least borrowed money - swishing around the world seeking increasingly risky investment opportunities.

Well that has changed for sure. In the space of a few weeks excessive appetite forrisk has flipped to excessive aversion to it. To those of us on the outside both attitudes might seem a bit ridiculous but that is the way human beings behave. The so-called wisdom of crowds, the idea that people collectively reach better judgements than they can could individually, evidently does not always apply.

Further, in finance as in other walks of life, very clever people can get things spectacularly wrong. The more substantial criticism of people in the global financial community is not that they got a bit carried away with themselves. Rather it is that they allowed the instruments traded in the financial markets to become so complex that they did not understand the risks they themselves were taking.

Most of the trouble has been in the US but we had an instance just this week in London where the Bank of England had to make a special loan to an unnamed financial institution to help it balance its books. It was a very short-term loan and there was no suggestion that the bank in question was in fundamental trouble: it had a liquidity problem, not a solvency one. But a well-managed financial institution ought not to find itself in that position and in normal markets it would not have done so.

From the point of view of the ordinary British employee or saver there is a bleak side to all this, and an encouraging one. The bleak side is that when financial markets throw a fit, the price of good assets tends to be depressed along with the price of bad ones. Share prices have accordingly fallen. The great thing about public share markets is that there is always a price for the shares in question. It may not be a good price; and that price may whiz all over the place for reasons totally unrelated to the performance of the company in question. But at least there is a price.

The result has been that good assets that can be sold have come down in price simply because they can be traded. The consequence of that is that the pension pot of ordinary UK working people will be rather smaller now than it was a month ago. Since the UK company sector had only just managed to rebuild its pension assets to an acceptable level it is a bit discouraging to see them pushed down again.

The more cheering consequence is that interest rates, here and elsewhere, may not need to rise by as much as had previously been expected. In other words, the level of rates needed to slow the world economy may be lower than it otherwise would have.

I do not think, however, that any of us should expect a significant early fall in interest rates. Central banks do not have a free hand in setting rates, for they have to act within not just the statutory obligations placed on them but within a wider responsibility for stable financial conditions. If they cut rates too much, inflation surges up and we are all in an even bigger jam.

It is pretty clear that the world's central banks - and I blame the US Federal Reserve more than the Bank of England - have made some serious errors in the past few years. In particular they dropped rates too low in the aftermath of the collapse of the dot com boom, trying to pump up demand. They succeeded but at the cost of creating a global asset bubble, particularly in property.

Yesterday, Stephen Roach, the new chairman of Morgan Stanley in Asia, made this point: "It is high time for monetary authorities to adopt new procedures - namely, taking the state of asset markets into explicit consideration when framing policy options. As the increasing prevalence of bubbles indicates, a failure to recognise the interplay between the state of asset markets and the real economy is an egregious policy error," he said.

I think that view is right and will, once the present ructions have calmed down, come to be accepted as the new orthodoxy. Central banks, including the Bank of England, will not be allowed to create another property bubble.

So what will that mean? Well, hazarding a few guesses, the end of the present global property boom is in sight and when it does comes to an end, there will not be another for a long time. That does not mean there will be a crash; just a period of much greater stability. Other major asset classes will be more stable too. That is no bad thing.

As for the world economy, as opposed to world asset markets, the present burst of growth will also come to an end. There is such a thing as a world economic cycle and we are not smart enough to iron it out completely. We have reduced its amplitude but there is still a cycle. So there will now be a period of slower global growth, starting maybe in 2008 or 2009. That too is no bad thing: far better to end this cycle with a whimper than a bang. So maybe not such a wicked August after all.