Diane Coyle: Stock market crash does not dictate a return to the 1930s

Past performance is an even worse indicator than usual of what lies ahead

One of the conventional weapons in the armoury of the more upbeat economic pundits at present is the observation that the stock market has predicted 11 out of the past five recessions. To put it the other way round, a forecast of an economic recovery after a crash in share prices has been more likely to be correct than a forecast of recession.

Sadly for the pundits, optimists and pessimists alike, past performance is an even worse indicator than usual of what lies ahead. The cult guru Marshall McLuhan famously pointed out that we march backwards into the future. Well, as far as the economy goes, we are hurtling onwards with our eyes fixed firmly on a past that we already know to be redundant as a guide.

The reason is that there has been significant structural economic change dating from around the mid-1990s. Just as 1973 marked, with hindsight, a turning point in economic performance for many countries, 1995 is shaping up to be another as far as it is possible to tell from the evidence available so far.

This is not necessarily a New Economy story, although there is room for explanations based on the spread of information technologies and the related investment boom. Rather, the tale begins with clear evidence of change in some basic macroeconomic relationships in a number of leading economies in the second half of the 1990s compared with the preceding 20 years.

For example, in the US and UK the unemployment rate has fallen to levels which would in the recent past have triggered higher wage and price inflation. There has been a decline in the unemployment rate below which inflationary pressures pick up, for reasons linked to job market reforms. This phenomenon is well known, but there have been other, less obvious, structural changes too.

One, documented in the latest Economic Outlook from the Organisation for Economic Co-operation and Development, is a marked increase in economic stability in the 1990s. The charts show the output gap – the gap between current output and its trend level – for the US and UK since 1960. Even at a casual glance it is obvious that the up and downswings during the past decade have been mild compared with earlier booms and recessions, and the statistics confirm this to be true for many of the OECD economies.

Of course, if the world is teetering on the precipice of a return to the 1930s, as some pessimists believe, the same charts in five years' time would reveal the Nineties to have been a lucky aberration. The absence of anything like the Opec shock of 1973-74 has obviously helped.

Yet there are sensible explanations for accepting the recent stability as a lasting structural change rather than dumb luck. One is that stability has everywhere become one of the goals of macroeconomic policy, and in many countries institutionalised in the independence of central banks. Another is that all the advanced economies are increasingly dominated by service industries, which tend to be more stable and less driven by big swings in inventories than manufacturing.

A related point is that the size of the public sector has continued to increase in most OECD countries. The growth of these tax-financed services has increased the component of fiscal policy that automatically stabilises cyclical swings in growth, for as growth picks up so do tax revenues, and vice versa.

A fourth factor affecting the business cycle is the deregulation of financial markets in many countries. Freer access to credit markets could stabilise an economy if it allows businesses and consumers new freedom to borrow through a downturn and pay back later, loosening the "liquidity constraints" that clearly applied in the past. On the other hand, there is a risk that asset price booms and busts could become more pronounced, and that greater indebtedness has increased people's sensitivity to changes in their wealth. These countervailing effects are difficult to untangle.

And as if all those changes were not enough, there is an international dimension, too, to business cycle patterns. Although it is hard to confirm the impression that growth has been more synchronised in different countries during the past decade or so, there has been a striking intensification of international linkages. The globalisation of financial markets means asset prices are more closely linked than in the past. We seem to pay each other more attention, so that business and consumer confidence often moves in step in different countries too.

The conventional link of trade in goods and services has grown in importance as well, of course. But, crucially, much of the increase reflects a genuine internationalisation of production so most trade in manufactures now involves exports and imports within industries of components, as opposed to trade in finished goods. This pattern of what Paul Krugman, an economist, has described as the "slicing up of the value added chain", or vertical specialisation across borders, is most pronounced in the most sophisticated industries such as electrical equipment, electronics and machinery. A growing number of economies are "supertraders", with imports and exports accounting for more than half of GDP.

On the face of it this means the international transmission of economic shocks will be much faster than in the past, as the example of semiconductors in the past few years suggests. However, imports and exports are more likely to move together, so the net effect on individual economies might well be more subdued. Global trade could be more sensitive to economic growth than it used to be because of the closer links between countries. On the other hand the emergence of a complicated international production chain might desensitise trade volumes to short-term changes in exchange rates and unit labour costs.

So far the changing trade patterns have either helped stabilise rather than exaggerate business cycles, or at least not offset the other stabilising trends. At this point, though, the only definitive conclusion is, as the OECD puts it, a bit less snappily than McLuhan: "past historical relationships may be a misleading guide to interpreting current and future movements in world trade."

There is plenty of evidence that underlying economic relationships have changed, then. On balance, it suggests the leading economies are more stable. But as we can't be sure yet, perhaps there is after all some comfort to be drawn from the things that never do seem to change – like the fact that stock markets have been a lot more vulnerable than the real economy to crashes through more than three centuries of fundamental economic transformation.

Diane Coyle runs the consultancy Enlightenment Economics.

Diane@enlightenmenteconomics.com