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Tuesday, August 19, 2008

We have financial, not economic, problems

Sometimes the markets just get things wrong. It doesn't happen very often. Usually the market's collective wisdom is more perceptive than the individual opinions of the investors who comprise it. But every now and then - about twice every decade - markets make spectacular blunders, completely losing touch with the real economy of consumption, investment, employment and world trade. The markets' behaviour last week suggested that such a time has arrived.

On Friday, share prices around the world collapsed as Wall Street was gripped by rumours about the bankruptcy of the two largest financial institutions in the world: the US Government-backed mortgage insurers Fannie Mae and Freddie Mac, whose combined debts are almost $6 trillion, equivalent to roughly double Britain's entire GDP. Yet what has been happening in the world of real economic activity to explain such extreme market action?

While Wall Street has gone into meltdown since the beginning of June, conditions in the real economy have been unambiguously improving. The latest employment figures, published two weeks ago, confirmed that economic conditions had stabilised after their sharp deterioration in the winter, while purchasing managers' surveys, the most reliable indicator of very recent economic trends, suggested a continuation of the modest but clear improvement that began in April. Sales figures from leading retailers were much stronger than expected, showing that tax rebates designed to provide a shot of financial adrenaline to all but the richest US households were doing exactly what the doctor ordered - offsetting the depressing effect on consumption of the credit crunch and the housing slump.

As a result, consumer confidence, although an unreliable and lagging indicator, showed its first improvement for six months. Even the figures on home sales have now been near-stable for four consecutive months, after almost a year of vertiginous falls. Most important of all, the monthly trade figures, published on Friday in the midst of the Wall Street meltdown, proved that the remarkably adaptable US economy was responding to the credit crunch exactly as the optimists had hoped - by undertaking an immense structural shift from consumer and housing-led growth to growth powered by exports.