Stephen King: So what has the stock market got to do with the real world?

In truth, not enough happened last week to explain why the markets saw such gyrations

Lots of people seem to think that stock markets are entirely rational. They believe in the so-called "efficient markets hypothesis". Presumably, therefore, they have a very good explanation for last week's events. One day, markets seemed on the verge of collapse. Then, over the next two days, markets staged an extraordinary recovery. So, what changed? To be honest, I have absolutely no idea.

I'm sure that the efficient markets hypothesisers will be able to come up with all sorts of post rationalisations. But "after the event" justification is never going to be terribly helpful. In truth, not enough happened last week to explain why markets suffered these extraordinary gyrations. War became a bit more certain. Economies got worse. Company results were a bit mixed. People began to speculate on the possibility of another interest rate cut from the Federal Reserve (there's a meeting this week). And that was the week that was.

So, do financial markets tell us anything at all? If markets follow an apparently random walk, up one day and down the next, should we simply ignore them? Should we just cast them to one side and focus, instead, on the real economy? Sometimes, the answer would seem to be "yes". Many people thought that the 1987 stock market crash would herald a recession but, over the following two years, most economies around the world boomed. In part, of course, this boom was a response to rapid changes in monetary policy that, in turn, were a consequence of the crash itself. Without them, perhaps the world economy would have flirted with recession. Nevertheless, it seems reasonable to argue that the worst fears associated with the 1987 crash were never fully met.

Which brings me to the current situation. The late 1990s saw the most almighty boom in stock prices. Over the last three years, we have just been through the longest bear market since the 1930s. Yet, the world economy seems to have survived rather well. The US went through a particularly mild recession and, since the end of 2001, has been expanding, albeit rather too slowly. Some countries in the eurozone went into recession and some in the eurozone are still flirting with recession: Germany is the most obvious example. The UK has, to date, come through mostly unscathed. And those countries in Asia that went through the 1997/98 crisis have come out the other side looking a lot healthier – from the point of view of corporate balance sheets – than they did at the time of the initial collapse.

This evidence might suggest that the biggest problem associated with stock market crashes is not the declines in share prices themselves but, rather, the possibility of policy error from those who are responsible for running our financial and economic affairs. Nowhere is this more obvious than in the 1930s. The monetarist view of this period is quite straightforward: the depression would not have happened if only the Federal Reserve had been prepared to supply liquidity to the economy in large amounts. Its failure to do so – its unwillingness to bail out those that had overly leveraged themselves in the first place – triggered a series of corporate collapses that led to a complete economic meltdown.

Similar arguments are also used about Japan's experience in the 1990s. The Bank of Japan is criticised for not cutting interest rates aggressively enough at the beginning of that decade. The Ministry of Finance is criticised for not being sufficiently accommodating on fiscal policy. And Japanese companies are criticised for their unwillingness to restructure themselves in "Anglo-Saxon" style.

As a result, there is a tendency to lump Japan's experience over the last decade with America's 1930s experience. Yet, apart from the declines in share prices, there are an awful lot of differences between the two cases. America's economy completely collapsed, with GDP falling by a good 30 per cent or so. Japan's economy just stagnated, simply unable to recover. America's collapse was matched by declines in activity in many other parts of the world: Japan's problems were juxtaposed against a decade of extraordinary economic success for other countries, notably the US and, increasingly, China. The 1930s marked a decade of trade barriers: the 1990s, in contrast, saw more and more moves towards free movement of goods and capital. And, whereas the 1930s were a decade of rearmament, the 1990s saw the arrival of the so-called "peace dividend".

In other words, lumping 1930s America and 1990s Japan into the same category is, at best, highly misleading and certainly does not make it easy to tease out the specific impact of changes in stock market values relative to the impact of policy error. Perhaps, therefore, it is better to revert to first principles, to ask what purpose stock markets serve and to what degree economies are potentially influenced by changes in stock market levels.

Ultimately, stock prices should say something about the future path for profits in the economy and something about the riskiness associated with those profits. The more that stock prices rise, the more likely it is that either profit expectations have gone up or the certainty of those profits expectations has increased. All sorts of factors will have an impact on this process. Is the macro-economic environment stable? Are firms able to retain profits or will competition reduce profitability? Is there a new technology that promises a substantial reduction in the costs of production? In the late 1990s, most of these factors were seemingly very favourable: inflation was low, companies were apparently very profitable (even though it turns out that some of them were lying). And new technologies promised much lower costs. No surprise, then, that stock prices soared.

A series of economic implications stemmed from this surge in stock prices. First, investment rose strongly – and so it should have done, given the implied rise in profitability. Second, debtors were happy to build up higher levels of debt – which makes sense if future income will grow more quickly and the risk of disappointment is less. Third, corporate pension fund managers could laze in their hammocks in the sun, taking holidays as pension assets rose without anyone even having to try. Fourth, the increase in supply – associated with strong investment – kept inflation in check, suggesting that the economic expansion could run and run.

Yet, as with all stock market bubbles, this virtuous circle could not be sustained. Excess capacity contributed to a collapse in profits. New technologies helped increase the degree of competition, placing permanent downward pressure on profit margins. The absence of inflation proved irrelevant to the sustainability of recovery. Pension fund managers have been unceremoniously dumped out of their hammocks. Borrowers have been left with debts that now look a lot less digestible. And the suppliers of funds – savers in general – have begun to have serious doubts about the safety of their capital tied up in equities.

The key issue, I suspect, is not one of boom or bust, recovery or recession. Rather, it is whether, over the long term, economic growth can be sustained at the rates that we've been used to in recent years. If falling stock markets imply lower profit expectations, surely they also imply a lack of appetite for risk taking. There's a big difference between a 1987-style crash – when markets bounced back quickly – and the kind of slow, painful, erosion that we've been through in recent years. And, in this new world of lower growth, we're likely to end up with big government – as politicians struggle to preserve jobs – heightened currency instability – as markets search for any residual growth – and the growing risk of protectionism. The recession may have been mild but it's the pace of recovery that is ultimately threatened by our stock market hangover.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com