Meghnad Desai: There's much worse financial news to come

Share
Related Topics

A bloodbath on the stock markets in London and New York has not been unexpected. There have been warnings for a long time that the markets were into a bubble of inflated share prices. Alan Greenspan, the chairman of the US Federal Reserve, chided Wall Street for its "irrational exuberance" as long ago as 1996. The level of share prices was below what it was yesterday.

In the six years since Mr Greenspan's remarks, sober economists and policy-makers have tried to understand why investors have been willing to pay a multiple of 30 to 40 times the earnings of a share. They tried all the standard theories of share pricing. None was adequate to explain the behaviour of investors. The market rose 50 per cent above its "irrational exuberance" level of December 1996 in the next three years. The FTSE 100 rose from 4,000 to 6,500 at its peak.

When markets are in a euphoric bubble like this, certain things happen inevitably every time. People begin to talk of a "new paradigm", of a suspension of old economic laws. This time it is really different, they say. It was tulips and the South Sea Bubble in the 18th century, railroad shares in the 19th century and this time it was IT and the new knowledge economy. People began to justify high share prices on fantasies of an explosion in profits, which was meant to be just around the corner. As the boom persists you read stories of the butcher on the high street who has plunged into the stock market, a sure sign of impending collapse.

Since around mid-2000 the stock markets have been gently coming down. However, the "real" economy in the US and the UK has been quite strong. There was a slowdown last year even before 11 September but that slowdown did not result in a recession. Indeed, the US economy bounced back to a strong performance of 4.5 per cent growth in the first quarter of 2002. The UK numbers were lower but may be revised upwards soon. The global economy escaped a Keynesian recession, but that was not the end of the story.

There has been a mis-match between the real economy and the financial markets for the last seven years. During the Asian crisis of 1997-1998, Mr Greenspan cut interest rates aggressively; he repeated that exercise last year. Cheap credit, available at rates of interest below inflation, expanded the stock market bubble for longer than necessary.

The American economy developed unhealthy habits of spending the high gains made on the stock market but not saving. America has also been importing much more than it exports. Its trade deficit has ballooned to nearly 5 per cent of its national income. This was all right while the world at large was pouring a billion dollars a day into the American stock markets but lately, thanks to Enron and WorldCom, there have been doubts. People are beginning to have doubts about the American stock markets; hot money is coming into Europe and abandoning New York. This is the story behind the slide of the dollar against the euro.

As if household profligacy was not enough, George W Bush was committed to a massive tax cut. Maybe his father should have tried a tax cut during his days in office, – that may have helped him win in 1992 – but Bush junior was committed to a tax cut even at the cost of running a deficit in his budget. After eight years of careful budgetary policy of the Clinton administration, which brought the American budget into surplus, we now have a yawning deficit for years to come. So America has a triple deficit problem: households in debt, the government in debt, and the nation in debt to the world.

Now there is a come-uppance: we have a Hayek crisis. Hayek warned about cycles of boom and bust way back in the 1930s. Cheap money makes people take foolish gambles with investment projects, which eventually pay much less than projected. There are "mal- investments" that have to be unwound. We now have to add "mal-accounting" that exaggerated profits and played down debts. There is more pain to come yet.

But the bloodbath is a cure for all that irrational behaviour. A level of about 3,000 is the right one for the Footsie. There will be bankruptcies and those fabulous City bonuses will be a thing of the past. But the real economy should not suffer too much if we keep our nerves. A big mistake now would be to panic and tighten monetary policy by raising interest rates.

For the British economy there is an additional problem: that our housing market is in its own bubble which is not bursting yet. It will be very difficult if both the bubbles burst at the same time. In that case there will be pain for ordinary households and not just for stockbrokers. It will be a very tricky problem for the Bank of England to make the housing bubble come down gently without expanding the stock market bubble.

Until now the Monetary Policy Committee has managed a sensible monetary policy but now it has to tackle two problems with just one instrument. This time it will be a real test of Gordon Brown's decision to give independence to the Bank of England in the first week of the new Labour government of 1997. Let us hope, for all our sakes, that he is proved right.

The author, a Labour life peer, is Professor of Economics at the London School of Economics

React Now

Latest stories from i100
Have you tried new the Independent Digital Edition apps?
iJobs Job Widget
iJobs General

Opilio Recruitment: QA Automation Engineer

£30k - 38k per year + Benefits: Opilio Recruitment: An award-winning consume...

Opilio Recruitment: UX & Design Specialist

£40k - 45k per year + Benefits: Opilio Recruitment: A fantastic opportunity ...

Opilio Recruitment: Publishing Application Support Analyst

£30k - 35k per year + Benefits: Opilio Recruitment: We’re currently re...

Opilio Recruitment: Digital Marketing Manager

£35k - 45k per year + benefits: Opilio Recruitment: A fantastic opportunity ...

Day In a Page

Read Next
Our political system is fragmented, with disillusioned voters looking to the margins for satisfaction  

Politics of hope needed to avert flight to margins

Liam Fox
David Cameron delivers his speech on immigration at the JCB World Headquarters in Rocester, Staffordshire  

Cameron's speech was an attempt to kill immigration as an election issue

Andrew Grice
Homeless Veterans Christmas Appeal: ‘We give them hope. They come to us when no one else can help’

Christmas Appeal

Meet the charity giving homeless veterans hope – and who they turn to when no one else can help
Should doctors and patients learn to plan humane, happier endings rather than trying to prolong life?

Is it always right to try to prolong life?

Most of us would prefer to die in our own beds, with our families beside us. But, as a GP, Margaret McCartney sees too many end their days in a medicalised battle
Thomas Cook's outgoing boss Harriet Green got by on four hours sleep a night - is that what it takes for women to get to the top?

What does it take for women to get to the top?

Thomas Cook's outgoing boss Harriet Green got by on four hours sleep a night and told women they had to do more if they wanted to get on
Christmas jumper craze: Inside the UK factory behind this year's multicultural must-have

Knitting pretty: British Christmas Jumpers

Simmy Richman visits Jack Masters, the company behind this year's multicultural must-have
French chefs have launched a campaign to end violence in kitchens - should British restaurants follow suit?

French chefs campaign against bullying

A group of top chefs signed a manifesto against violence in kitchens following the sacking of a chef at a Paris restaurant for scalding his kitchen assistant with a white-hot spoon
Radio 4 to broadcast 10-hour War and Peace on New Year's Day as Controller warns of cuts

Just what you need on a New Year hangover...

Radio 4 to broadcast 10-hour adaptation of War and Peace on first day of 2015
Cuba set to stage its first US musical in 50 years

Cuba to stage first US musical in 50 years

Claire Allfree finds out if the new production of Rent will hit the right note in Havana
Christmas 2014: 10 best educational toys

Learn and play: 10 best educational toys

Of course you want them to have fun, but even better if they can learn at the same time
Paul Scholes column: I like Brendan Rodgers as a manager but Liverpool seem to be going backwards not forwards this season

Paul Scholes column

I like Brendan Rodgers as a manager but Liverpool seem to be going backwards not forwards this season
Lewis Moody column: Stuart Lancaster has made all the right calls – now England must deliver

Lewis Moody: Lancaster has made all the right calls – now England must deliver

So what must the red-rose do differently? They have to take the points on offer 
Cameron, Miliband and Clegg join forces for Homeless Veterans campaign

Cameron, Miliband and Clegg join forces for Homeless Veterans campaign

It's in all our interests to look after servicemen and women who fall on hard times, say party leaders
Millionaire Sol Campbell wades into wealthy backlash against Labour's mansion tax

Sol Campbell cries foul at Labour's mansion tax

The former England defender joins Myleene Klass, Griff Rhys Jones and Melvyn Bragg in criticising proposals
Nicolas Sarkozy returns: The ex-President is preparing to fight for the leadership of France's main opposition party – but will he win big enough?

Sarkozy returns

The ex-President is preparing to fight for the leadership of France's main opposition party – but will he win big enough?
Is the criticism of Ed Miliband a coded form of anti-Semitism?

Is the criticism of Miliband anti-Semitic?

Attacks on the Labour leader have coalesced around a sense that he is different, weird, a man apart. But is the criticism more sinister?
Ouija boards are the must-have gift this Christmas, fuelled by a schlock horror film

Ouija boards are the must-have festive gift

Simon Usborne explores the appeal - and mysteries - of a century-old parlour game