Hamish McRae: The markets are bad, but don't panic yet

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The Independent Online

We have been round this block before, haven't we? Market turmoil, emergency rescue, recession looms, grim-faced Chancellor warns that we have to tighten our belts. All right, we have yet to have that last bit of the sequence but the poor little chap has yet to present his first budget. Wait till March.

The important thing, when faced with any financial panic, is to distinguish between what is happening in the markets and what is happening in the real economy. The two are linked, of course: market crashes undermine economic confidence and may undermine growth and employment, while a strong economy will usually be reflected in buoyant asset prices. But you can have market crashes without a corresponding economic decline and vice versa.

After the crash in October 1987, the world economy continued expanding for another three years, and the worst longer-term decline in world share prices for a generation, from 2000 to 2003, was associated with a relative mild global recession. By contrast, until about 18 months ago the Chinese economic boom had taken place alongside a terrible stock market performance. Since then, it has shot up, but for many years the world's fastest-growing economy had the world's worst-performing stock market.

So we should not assume that this sharp reaction in world shares prices, even if it persists despite the emergency cut in interest rates yesterday by the Federal Reserve, is necessarily signalling that there will be a global recession this year. Some sort of slowdown is taking place and some countries, including the US and maybe, to a lesser extent, the UK, will suffer worse than others.

But the world economy, and indeed the UK one, is still growing solidly and it will take some time for that momentum to come off. And there is no reason to suppose that the next global downturn will be more serious than the previous three, in the early 1980s, early 1990s and early 2000s. As far as the UK is concerned, I happen to think that it will be less serious than the first two of those, but more serious than the most recent dip.

The thing to be clear about is that the US matters but it does not matter as much as it used to. Last year, for the first time in a couple of centuries, China added more demand to the world than either the US or Continental Europe. It is not immune from a recession in the US but its fastest-growing markets are elsewhere in Asia, not the States. As for the US, the fall in the dollar has already started to correct its current account deficit and the long boom has largely corrected its fiscal deficit.

So, sure, there will be a rough couple of years there, which may or may not dip into the technical definition of recession: two successive quarters of negative growth. But there are things the Fed and the Administration can do, cutting interest rates and making some tax cuts, that will help the economy through these tougher times. Expect also a continuing flow of investment funds into the US to take advantage of the weak dollar. The States has to sell solid assets to pay for its past excesses and that is not very smart but it is still a huge and efficient economy.

Here we face similar problems. The excesses in our housing market and our banking system may not be quite as extreme, but our current account deficit and budget deficits are actually wider. Indeed our budgetary position is dreadful: it looks very much as though the Chancellor will miss his upwardly-revised borrowing target for this financial year and next year hardly bears thinking about. Unlike the US, we cannot cut taxes to offset the slowdown, though we can and will cut interest rates. And we are unusually dependent on the financial services industry to pull the economy along, the industry most directly damaged by all the market mayhem.

But other countries have problems too. Germany is the world's largest goods exporter so, on that basis, should be hardest hit by a downturn in global trade. The high euro damages all European exporters. Spain has a worse housing bubble than even the UK. More than one-fifth of Japan's exports go to the US and the mood there is just as bad as in the rest of the developed world.

However, in calibrating all the mass of economic junk that is flooding out at the moment, you have to remember that the world has just had one of the fastest-growing years it has ever experienced. So it would be pretty amazing if things did not ease back a bit. Here in the UK, we have this particular problem of a large and growing fiscal deficit but we also have, at the moment at least, record employment and we have just had a year of growth of more than 3 per cent. The latest surveys of industrial opinion are gloomy but not that gloomy. Everything points to a slowdown rather than a collapse.

So why are the markets collapsing? The short answer is that they always overreact and at the moment are having one of their periodic mood swings from greed to fear. Three months ago, shares worldwide were at an all-time high. Despite the fact that here they just failed to reach their previous peak at the Millennium, we have still had five years when shares ended the year higher than they started. Even last year, they were up a tiny bit. That is very unusual. I may have missed one, but I cannot find any period in the past 150 years when UK shares have risen for six years on the trot. So for shares to end higher this year, which actually I think they still may, would be unprecedented.

So you can explain the present falls in terms of a natural and inevitable reaction, if a delayed action one, to the other financial strains of last year, in particularly the pressure on the banks. Bankers, like the rest of us, make mistakes, but the scale of the mistakes, particularly in US banks, has been enormous. We won't fully understand for some time quite how they could persuade themselves that bundles of housing loans to clearly uncreditworthy borrowers should be ranked as almost as good as government securities.

But it is easy to understand why they have been taken aback by the collapse of trust in the money markets because the last serious breakdown in the London interbank market was back in the 1970s. The most really scary thing then was a rumour that NatWest was going bust.

The legitimate question now seems to me to be whether the continuing banking weakness has become so serious as to transfer what is still a financial market problem into a more general economic problem. I cannot believe it will for three reasons. One is that core loans on which the banks have made these large paper losses are still going to be worth something. Two is that interest rates can and will continue to come down and that will cut bank funding costs. And three, as we have learned with Northern Rock, we taxpayers have to support any bank that gets into trouble. Banking troubles will be a drag on the world economy, slowing it down. But they won't stop it in its tracks.

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