The Nikkei Financial Daily (Market Eye Column), 13th March 2007
The distinguished economist John Lipsky, who is First Deputy Managing Director of the IMF, recently remarked that the current state of the world economy was so good that we had the luxury of being able to indulge in worries about financial markets. In the light of recent market turmoil, this amusing and sensible comment risks being prescient, as it is far from unusual for financial markets to pose the major risk to economic stability.
Outstanding examples of a dramatic stock market decline being followed by severe economic disruption include the US slump of the early 1930s and Japan’s economic stagnation since 1990. But even less unpleasant recessions, such as that in the US in 2001, have been commonly heralded by falling share prices. Financial turmoil does not always indicate that the economy is heading for trouble, but it is rare for sharp fluctuations in output not to be thus signalled. It is an old but true joke, that stock market falls have predicted seven out of the last five recessions.
The importance of financial markets as a leading indicator of the economy is well known, but is often ignored. The major reason why so many forecasters prefer to pay no attention to their significance is that the timing of financial market fluctuations cannot be predicted. If it could, investors would sell or buy in advance of the change, to the point where the oscillations would not occur.
As markets are both unpredictable and important for economic forecasts, the latter must either be relatively short-term, or make some assumption about financial conditions.
The time-lag between stock market falls and their impact on the economy is around nine to twelve months, so that economic forecasts are reasonably safe if restricted to the next year ahead. Where a two year or longer forecast is needed, it is usual to assume, at least implicitly, that financial conditions will remain benign.
This is often ignored by those who seek to forecast stock markets. It is common to encounter the foolish argument that, because it is agreed that the economic outlook for the next one or two years is benign, it follows that the stock market will prosper. The argument is of course completely circular. The optimistic consensus is based on the assumption that markets will remain benign and cannot therefore sensibly be used to support a forecast that they will be so.
The importance and unpredictability of financial markets means that the economic outlook is at its most uncertain if the time horizon is two or three years ahead. For different reasons, both the shorter and the longer term outlook are more settled.
Until very recently financial markets have been buoyant and, in the light of this, it is unlikely that a recession will develop within the next nine months but, if stock markets fall significantly during this period, this is likely to lead to sharp fluctuations in output over the medium-term. Further ahead, output should recover, as this will allow time for policies to deal with these difficulties to be introduced and to become effective.
Such problems are quite frequent, but their incidence is not regular and inevitable. If markets stabilise quickly, then output will tend to rise on its current trend for the next two or three years, rather than just the next one. Even if the US stock market falls sharply, a recession is likely rather than certain.
As John Lipsky has suggested, the major economic risks, as distinct from knock-on problems arising from politics or epidemics, currently seem to lie in financial markets. In recent years the prices of bonds, equities, gold and houses have moved up to very high levels, at least in most major economies. This has been the result of easy monetary policies designed, so far very successfully, to keep the world economy strong.
The rise in asset prices relative to incomes is almost certain to reverse over time. An adjustment between asset prices and incomes can come either through falls in asset prices or a rapid and inflationary rise in incomes. It seems unlikely that the world’s central banks will willingly accommodate the latter. Falls in asset prices are thus likely at some stage, and we may of course be seeing the first signs of this over the past few days. When asset prices do fall they will have a depressing impact on demand, particularly in the US, where the rise in house and share prices have boosted consumption by discouraging savings.
It is therefore both reasonable to expect the world economy to remain buoyant over the next nine months, and reasonable to worry that this will not continue thereafter, should the recent weakness and volatility of stock markets continue.