More art than science in judging markets' impact

The issue is how strong the links are between the financial markets and the real economy
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The Independent Online

Is the present financial market unease likely to damage the real economy?

Is the present financial market unease likely to damage the real economy?

That the markets are touchy is beyond dispute. Yesterday was a good example that when markets are running scared any bad news such as we had from the Middle East has a sharp impact. But they have been worried for weeks.

In the hi-tech region any hint by a company that things might not be quite perfect slams the shares, as we have seen with companies such as Motorola and Lucent this week. The hi-tech malaise has not yet spread seriously to the mainstream financial markets - in cases where a firm has seen its shares panned the problems are usually company specific. Nevertheless it is quite possible that this year will be the first for a decade in which Wall Street ends down rather than up. If that happens, well, put it this way, it was not in the brochures of the US investment banks at the beginning of the year.

The issue then is how strong the links are between the financial markets and the real economy. Some markets - such as oil - have a direct link. You can calculate with reasonable precision what impact a rise of, say, $10 a barrel in the price of oil will have on global demand and inflation. You can see how some countries will be hit harder than others, and how some others will actually benefit. Incidentally you might be interested to know that the UK is among the net beneficiaries, since we are still just net exporters of oil.

But with financial markets there is no such easy calculation. Neither the impact, nor the time scale is clear. Financial markets are a reflection of attitude and to some extent even a predictor of economic events, as much as a shaper of them. So untangling the relationship is more an art than a science. Still, it is at least possible to separate the potential links and see how they might apply.

The easiest way to get a hold of this is to distinguish between the impact on consumers, the impact on companies and investment and the impact on risk-taking and innovation.

Market jitters affect consumers mainly because they feel their stock of wealth is declining. This effect varies greatly from country to country. On the Continent it is pretty small because personal share-holdings are small, though now growing very quickly. In Britain, it probably does exist but the housing market is much more important. In the US, however, the effect is considerable.

You can see a measure of this on the top chart. The 1990s boom in US financial markets has been mirrored in a plunge in the savings rate. Through the 1980s, despite the swings in the economy, savings stayed pretty much the same. But during the past 10 years they have plunged and are now negative. Americans are living beyond their means.

Now there are a host of qualifications that have to be made. Savings are falling not just because of rising share prices but also because of confidence that unemployment will stay low. People argue that if they overcook things and have to pay back debt, they can at least be assured that they can earn their way out of the problem. Also, the actual savings rate may not be as low as it seams because many Americans, unlike most continental Europeans, have additional financial resources in their funded pensions schemes.

Nevertheless, a sustained fall in share prices must have some effect on US consumption. Trouble is, we don't know how low shares have to go, or how long they have to fall, before this becomes significant. All we do know is that this is an area to watch with lidless eyes. Consumption is typically 60 per cent of any economy, so quite small swings have an enormous impact. Add in the fact that nearly 40 per cent of the world's consumption takes place in the US and you see the importance of the American consumer to the world economy.

For investment the links are two-fold. Companies invest because they can see the prospect of profitable demand. So they have to be sure of the level of demand, which will ultimately depend on consumers. But they also, more mechanically, need to be assured of the cost and availability of capital. Weak financial markets mean more expensive funding.

The pattern varies vastly from country to country, from sector to sector and from large to small. But at the moment for many large companies funding expansion via a share issue is unattractive. The new shares would have to be placed at too deep a discount to the existing ones, and in some cases the market might be too weak to get a share issue away at all. For New Economy companies the latter is the harsh reality.

There are the bond markets but they too are edgy. The spread between the rate charged to top-quality companies and less high-quality ones has widened sharply. In fact the market has almost dried up for OK but not particularly strong risks.

If you cannot issue new shares or new bonds what other options are there? The only other significant possibility is bank borrowings. That market at the moment remains open but in the last few weeks the banks have come under fire for lending so much to telecommunications companies and there have even been suggestions that the banks are undermining their own security as a result.

This is quite alarming because telecoms are among the giants at the frontier of the New Economy boom. If they become strapped for cash maybe the whole burst of innovation will be checked.

The bottom chart shows how important the hi-tech sector is to the US economy. Growth there has been racing along at 8 per cent a year or thereabouts, while growth in the regular economy has been more like 1-2 per cent. Were it not for the New Economy, US growth would be pretty lacklustre: it would certainly be growing too slowly to justify current market expectations.

So there is a danger of a self-feeding spiral, where a squeeze on the hi-tech companies causes them to rein back on investment, which in turn leads to lower growth and so on. None of this is sure, of course, but the link is obvious.

The final twist to the tale is the impact of lower markets on innovation and risk-taking. The market for funding hi-tech start-ups has just about dried up in the UK, so a vibrant, though small, part of our economy is being stifled. That is bad news for the medium term, though not particularly important in the very short term.

In addition, this mood is feeding into the large companies, where risk-taking is also going out of fashion. You cannot calculate the macroeconomic impact of this. But it casts a long shadow for markets need risk-takers - of the right sort.

That may turn out to be the most significant link of all between financial markets and the real economy.