Markets' wild ride sounds warning bell for world economy

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The Independent Online

There have been two big global economic stories this week - the collapse of the Nasdaq index in New York and the upgrading by the IMF of its estimates for world growth. Question: could the first undermine the second?

Yesterday the Nasdaq did better and who knows where it may head in the next few months. But the market's sheer volatility should be a cause for alarm. As the first graph shows, the Nasdaq has had an extraordinary three- and-a-half months, and volatility itself is discouraging to investors. The losers will naturally be less than thrilled and even the ones who have made money from the swings will be aware that these are dangerous times. Risk normally leads to prices at a discount, but in these strange times the most volatile markets are also the most highly rated. This is unlikely to last.

To get another fix on the scale of the downgrading of hi-tech securities look at the other graph. This shows the Goldman Sachs index of internet stocks since the beginning of last year. The point here is that the level of internet stocks is not only down a long way from the twin peaks around the turn of the year, but it is also well below the peak of last spring. In so far as there was indeed an internet bubble, it has indeed been burst.

Will that feed through into aggregate demand? Probably not unless market declines widen and deepen. You have to set against the Nasdaq falls the fact that the US market in general (as measured by the S&P 500 - see graph) has not performed at all badly this year. Look global and Japanese share prices have done very well and most of the European bourses likewise. US consumption may eventually take a hit but there is no evidence of that yet. And global consumption has no reason to fall as a result of declining asset prices: viewed globally there has been no decline in asset prices, rather the reverse.

Will rising interest rates by the central banks clobber demand? Certainly not yet. In both the United States and in the eurozone financial conditions have not been tightened this year.

In the US, as Goldman Sachs points out in a recent newsletter, the rises in interest rates have been offset by strong asset prices, and in the eurozone they have been offset by the weak euro.

Nevertheless, the IMF forecasts for world growth are so bullish that they give rise to an uneasy feeling: it is always those moments when everything looks too wonderful that we should all beware.

The IMF's forecasts are competent, clear and rational. My principal reservation about them is the growl against the last UK Budget seems a bit "old economy".

The Fund authors regretted that the additional spending in the Budget had come at a time when the economy was expanding strongly and would add to the pressure. Rationally, that is right. But the scale of the fiscal boost is not very significant. Short-term movements in consumption in the UK are determined much more by monetary policy than by fiscal policy. Thanks to the link through mortgages and house prices we are particularly sensitive to changes in short-term interest rates. Mortgages affect consumption directly by altering disposable income and house prices affect it indirectly through the so-called wealth effect: people spending more because they feel richer. Swings in interest rates and in confidence are far more important than swings in the financial position of the public sector.

So, as a result of the Budget, interest rates will have to be a bit higher in the coming months than they otherwise would have been. But not that much.

What we will see for the rest of this year is increasingly determined efforts by the central banks to lean against excessive growth. Goldman calculates that the Fed would have to increase interest rates by 1.5 per cent to offset a rise of 10 per cent in share prices, while the European Central Bank would have to increase its rates by 3 per cent to offset a fall of 10 per cent in the euro. So far neither has succeeded in tightening much; any rises they have made in rates have merely offset slightly the expansionary forces at work. Expect more.

How much more depends on the view you take of the ability of the world economy to expand without running into excessive inflationary pressures. The Goldman view is that the world could stand another couple of years of strong growth, for there is plenty of spare capacity in manufacturing and the threat from higher oil prices seems to have receded. The IMF is more twitchy about the risks, but both agree that the problem will be next year rather than this.

So the great question is whether the world can adjust from faster-than-trend growth in an orderly way or whether there will be some kind of discontinuity. The danger is that a fall in asset prices would happen just at the moment when rising interest rates started to bite.

My best guess would be that the problems for the world economy will occur in 2002 rather than this year or next. Even if the Nasdaq has a dreadful year (which it may), the fact that other markets, including the Dow, will be more stable will mean that falling asset prices will not rein back the world economy until well into 2001.

The thing that would upset this guess would be if Nasdaq's gyrations were to undermine more generally the confidence that Americans have in their New Economy. There is little sign of that.

What is happening is that the initial exuberance has given way to a cooler appraisal of the winners and losers, and a realisation that most of the winners will be old-economy companies that adapt well to the new possibilities. But if you want to look for warning signals, that is the corner to watch, listen and learn.