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

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