Stephen King: Such woeful markets call for a radical change in ideas

There seems to be a growing concern that traditional monetary measures are failing

Over the past few weeks, I have written about the dangers of persistent declines in the stock market. These dangers range from wealth effects – people seeing their hard-earned savings going down the equity drain – through to "animal spirit" effects, whereby falling stock prices point to collapsing expectations for future corporate profitability. Either way, there is at least the possibility of something nasty lurking somewhere over the horizon. Lower growth on a long-term basis, perhaps. Maybe an unpleasant dose of deflation.

Of course, these things need not come to pass. Declines in equity prices have happened before and the world economy has not been completely written off. However, the duration of the latest period of equity market weakness suggests that there is certainly something odd going on. Even if it is not your central forecast, the whiff of deflation suggests that central bankers may have to sit back and take stock before adjusting interest rates to the usual cyclical developments.

Judging by my trip to the US last week, however, the debate has moved on a bit further. Although this may just be the result of the latest financial panic – referred to by Alan Greenspan, chairman of the US Federal Reserve Board, in his Congressional testimony as "skittishness" – there seems to be a growing concern that traditional monetary measures are in danger of failing.

In one sense this seems like an odd conclusion, given the strength of cyclical recovery seen in the first half of this year. Yet, memories of Japan's experience 10 years ago appear to have created a sense of unease about the sustainability of the recovery. Could it be that the declines in equities are not only suggesting that the medium-term outlook for economic performance is not so good but, more worryingly, that interest-rate policy is simply not working very well?

This is, of course, a variant of the old liquidity trap arguments, whereby interest-rate cuts beyond a certain level, perhaps linked to deteriorating "animal spirits", simply stop providing any significant economic benefit. But it has spawned a series of discussions about "unconventional" policy options. If interest-rate cuts alone don't do the trick, are there more radical policies that could be adopted to restore confidence in the short term and economic health over the medium term?

There are a few that are worth thinking about. One familiar refrain is for the monetary and fiscal authorities to intervene directly in the equity market in an attempt to rebuild confidence from an "oversold" position. In effect, this would copy some of the price-keeping operations seen in Japan – without any significant success – during the course of the Nineties.

The problem, of course, is knowing when an equity market is truly "oversold". My first chart, for example, which looks at the price/earnings ratio on the S&P 500 index, suggests that, apart from the bubble period in the second half of the Nineties, the market is still on the pricey side (although there's always the possibility that corporate earnings will bounce back very strongly). On this basis, direct price-keeping operations might simply delay the inevitable, turning a potential crash into something more akin to a Chinese water torture.

A second option is for the monetary authorities to intervene more rigorously in the bond market. One problem with loosening monetary policy is that short rates typically fall a lot further than long-term interest rates (see my second chart). Generally, this is seen to be quite a good thing because a steep yield curve typically rewards banks to a greater degree for their lending activities, thereby boosting the money supply. Yet, if the collapse in "animal spirits" is coming from within the corporate sector, a failure of long-term borrowing costs to decline could reduce the demand for credit, even if the potential supply is there. On this basis, it might be possible for the Fed to buy longer-dated bonds, thereby lowering borrowing costs for the corporate sector. This might have some chance of success if adopted quickly enough. Japan did eventually embrace this option, but was too late to have any material impact on economic performance.

A third option would be for the monetary and fiscal authorities to print money. For the US, the simple thing to do would be for the Treasury to announce significant tax cuts and fund these cuts by borrowing not on the markets but rather from the Fed directly. The money supply would inflate and, theoretically, there should be no significant effect on interest rates. However, a lot depends on the subsequent response of the private sector. Printing money is considered to be highly suspect: after all, all great inflations have their roots in the printing press. Should the policy not be credible, inflationary expectations could raise bond yields, thereby making life tougher for companies faced with at least a short-term absence of pricing power.

So far, I have considered domestic options. But there are other choices that might have significant international consequences. The most obvious – my fourth option – is a sustained period of dollar depreciation. The aim would be to divert the source of US economic growth away from domestic consumption and investment towards exports. It is a policy that worked well for Sweden at the beginning of the Nineties.

Unfortunately, however, the US is not another Sweden, because Sweden's success was partly an issue of size. Its devaluation came at little cost to the rest of the world, for the simple reason that Sweden is a small economy. The US does not have the same advantages: a major dollar depreciation could simply be regarded by other players as a "beggar-thy-neighbour" policy that could have all sorts of nasty repercussions.

Finally, there is the option of last resort. If US companies have been pummelled not just by internal accounting problems but also because of the increased competitive environment at the global level, one way to deal with this problem is to re-erect barriers to entry which, in the short term, would enable companies to rebuild profitability. If companies cannot do this themselves, the government could step in with a few less-than-friendly trade barriers. One would hope that this is not a terribly likely outcome – it reeks of the Thirties – but the US Administration's "America first" policy as revealed in the imposition of steel tariffs – creates a worrying precedent.

Doubtless, there are other options as well. Maybe they will never be needed. But should asset prices remain weak in the second half of the year, and should growth stall, there will be a lot more worries about the efficacy of monetary policy. And, although there is still room for interest rates to fall further if need be, this room is fast running out. These are unconventional times: time, perhaps, to brush off the weird and wonderful ideas hidden away in the most obscure economic texts.

Stephen King is managing director of economics at HSBC