Commentary: Do falling share prices matter?

By HAMISH McRAE

LONDON - Do falling share prices matter? Kinda stupid question, eh?

Well, of course at one level they matter because unless the markets recover reasonably quickly the millions who rely on investments to pay for their pensions are likely to have a somewhat less comfortable retirement than they might have expected. But at the more general level the question is worth trying to answer because our whole economic prosperity could be under threat.

Could be – but not yet. The collapse of share prices over the past two years may well go further but already it is of a once-in-a-generation magnitude. If past history were any guide, you would only see two or such crashes during a lifetime. You have to go back to 1973/4 to see anything like it: shares down two years in a row (and now maybe three) and a fall from peak to trough on the FT100 index of more than 40 per cent. Before that, you have to go back to the Second World War; before that, 1929.

What is therefore odd is that these declines should be taking place in a period of real prosperity. There is no world war, no serious global slump. In the early 1970s there was the first oil shock, the miners' strike, the three-day week and inflation in double digits.

Now, in Britain at least, there has not even been a recession. Output has not fallen for one single quarter, inflation is down to 1.5 per cent and our Chancellor is confident that growth will continue at more the 2 per cent this year and 3 per cent next. Something really strange is happening.

Whether it matters – I mean really, really matters on a five or ten-year view – turns, I think, on two things. The first is whether disruption in the financial markets undermines the progress in the real economy; the second, whether the markets, in their incoherent, stumbling way, are telling us that there are grave dangers ahead that they don't understand but don't like.

Disruption in financial markets always has some knock-on impact on the real economy. Given the destruction to wealth that has taken place, at some stage that will feed through into consumption. If people feel poorer – are poorer – they spend less.

The trouble is, the lags between the decline in wealth and how people behave are long and uncertain. They are different in different countries. In the United States the stock market wealth of individuals is roughly the same as their housing wealth. Here in the UK the housing market matters more and up to now the housing market has remained strong (as, incidentally, it has in the US). But share weakness can feed through to housing and already there are signs that house prices have topped out. As people realise that the market is turning, it could come off quite quickly.

The truth is, though, we don't know whether there is a serious threat to consumption from falling share prices. We know there is a threat of sorts but we don't know the scale or the timing. So far all seems well, but keep fingers crossed.

Might there be a threat to the business community? If the UK and the US ran bank-financed companies like Japan and Germany then there would be a serious threat to the stability of the banking system. Japan's banks are in a desperate state, Germany's not as bad, but under pressure. But the share-based version of capitalism is inherently more stable. If a bank has dud debts and its depositors want their money back it goes bust. If share prices fall it still hurts but the pain is more widely spread.

So I don't think there is any evidence yet that US or UK financial systems are as gravely wounded as the Japanese – so wounded that they are unable to crank up any growth at all. But we do need a recovery in financial markets reasonably soon because if we don't get it, the whole company sector will find it cannot raise money for new investment. It will be forced to play safe, cut back investment, conserve cash … and thereby jeopardise the very economic recovery the market needs.

That leads to the second fear: are the markets trying to tell us something that they don't understand and we don't want to here?

It is very hard to see quite what this might be. In 1930 the fear was world slump and the rise of protectionism. During the Second World War the fear was of an even greater catastrophe. In 1973/4 it was that this country had become ungovernable, and elsewhere that the whole capitalist model was under grave threat from ever-rising inflation. There really is nothing like that now.

There are more limited threats. I don't think people in Europe appreciate quite how angry and insecure the US remains post-September 11. The feeling that it has been let down by its own corporate leaders, too many of whom have lied about company performance as they lined their own pockets, resonates with the underlying angry insecurity.

The concern at inaccurate corporate accounting was acknowledged yesterday by Alan Greenspan, chairman of the Federal Reserve Board, in his testimony to Congress. But it was also implicit in his statement that eventually these worries would be tackled. What ultimately matters is that US growth is sustained.

We in Europe feel threatened because we need a secure and growing US market. Just as Europe depends on the US for military security (even if it disagrees with it) it also needs the US for demand. In the UK domestic demand is still quite strong, but in the eurozone it is actually down 1 per cent year-on-year. The eurozone in general and Germany in particular desperately needs exports; the higher the euro goes the tougher those will be. So though we don't have the corporate dishonesty of the US (we have corporate incompetence but that is different) we still suffer from US insecurity.

Where the US and Europe are in the same boat is the sense of disappointment about the apparent failure of the new technologies to generate wealth, the high-tech hangover. This really should not surprise us. All the experience of similar new discoveries in the past suggests that the telecom and internet bubbles are following a familiar pattern. Look at the railways, the telephone, the motor car, the radio – all these led over time to huge changes in the way we live and eventually to huge increases in standards of living. But people over-estimated the short-term effects and underestimated the long-term ones. As a result many of the original investors got burned.

If the market malaise is just a reflection of angry insecurity and disappointment about the speed at which the technology revolution has brought rewards, then things should be all right. Barring some catastrophe in the Middle East they will recover their nerve and maybe do so quite quickly. If they are fretting about something more – perhaps a fear that the world will find it hard to make the transition from inflation to price stability without serious disruption – then, well, the next five years could be difficult indeed.

Of course there is a simpler explanation for all this gloom and doom. The markets could simply be wrong. That has been known to happen, has it not?

- INDEPENDENT