Tumbling markets are sometimes good predictors of an economic downturn. But not always.
The current fall, for example, looks more like a punishment for the collective folly of investors than any sort of prophecy. But an uncontrolled market decline could eventually jeopardize growth prospects.
There’s no problem right now. The International Monetary Fund recently raised its forecast for global growth in 2007 from 4.9% to 5.2%. China, India and Russia are expected to supply about half of the total gain, offsetting softer growth in the US. Yet, the US is not doing badly, after a poor first quarter. European growth has slipped, but has been running at a quite respectable 2.5% rate.
The markets aren’t paying attention. Rising inflation and the steady increase in interest rates since 2003 have burst the speculative bubble in US housing. That has triggered what might politely be called a generalized repricing of risk, in other words a hammering of both credit and stock markets.
But even if the markets aren’t making an economic call, they may yet cause an economic fall.
There are two big risks.
First, the receding liquidity tide that could leave one or more important financial institutions washed up on the beach. In the old days, central banks—the lenders of last resort—would mop up the mess fairly quickly. But with all the complex risk-sharing securities out there, it might take years to get the system back in order. Meanwhile, the real economy could be crippled by a lack of finance.
Second, even if financial institutions muddle through, households’ finances could be badly hurt. Consumers’ balance sheets are under threat, especially in the US and the UK. Falls in the value of stocks, bonds and houses would hit the asset side, without touching the liabilities, which are at a record level. Up to now, lower incomes have hardly dented spending, but if credit is less readily available, consumers will be forced to pull back, hurting demand around the world. That could lead to a recession.
Then the markets would be proven right, although only by (financial) accident.