Please note that this is BBC copyright and may not be reproduced or copied for any other purpose. RADIO 4 CURRENT AFFAIRS ANALYSIS FOLLOW THE LEADER? TRANSCRIPT OF A RECORDED DOCUMENTARY Presenter: Diane Coyle Producer: Simon Coates Editor: Nicola Meyrick BBC White City 201 Wood Lane London W12 7TS 020 8752 6264 Broadcast Date: 15.08.02 Repeat Date: 18.02.02 Tape Number: TLN232/02VT1033 Duration: 27.40 Taking part in order of appearance: Mark Cliffe Chief Economist, ING Markets, London Danny Quah Professor of Economics, London School of Economics & Political Science Nicholas Crafts Professor of Economic History, London School of Economics & Political Science Robert Shiller Professor of Economics, Yale University and author of Irrational Exuberance Bill Martin Chief Economist, UBS Global Asset Management, London Peter Warburton Consultant to Ruffer Investments and author of Debt and Delusion Robert Brenner Professor of History and Director of the Center for Social Theory & Comparative History, University of California, Los Angeles and author of The Boom and the Bubble COYLE Billions of pounds – and dollars – of investors’ wealth have been wiped out by plunging share prices. Panic’s certainly been catching and, judging by recent headlines, recession now looks like it could be, too. The American economy may be dragging the rest of the world into a downturn. Nothing to cheer about then for those companies whose shares have been at the centre of the turbulence on Wall Street? CLIFFE It does seem as though the ordinary business of corporate America is, at the moment, proceeding fairly smoothly. Orders are picking up, they’re achieving decent sales and, indeed, their profits are picking up. Of course, you wouldn’t believe this from the media or from the behaviour of the stock market, but that is actually what’s happening on the ground. COYLE Mark Cliffe, chief economist at ING Markets, has recently returned from visiting a range of companies across the United States. Perhaps it’s just too hard for the City to give up the habit of optimism. But presumably Professor Danny Quah of the London School of Economics can dispel any lingering doubts we might have about the gloomy economic prospects. QUAH What’s interesting is that looking forwards from here, things look distinctly rosy, things look on balance, things are on track. The US economy grew by 6.7% year- on-year in the first quarter, actual growth now on average over the last six, seven years is about double what it was for the previous twenty, interest rates are low world wide, inflation is low world wide. Consumer wealth? Yes, that’s taken a distinct hit in the stock market, but consumer wealth held in the form of housing is remarkably strong and remarkably strong not just in this country but world wide. COYLE So although the US spent most of 2001 in recession – and plenty of voices are eagerly predicting it’ll soon dip back into that unhappy state – its vital signs are surprisingly good. Take that recession last year. It followed a record-breaking, decade-long expansion and up to now it’s been the shallowest downturn since 1945. So what’s the connection between what the markets do and how economies perform? Will the extraordinary economic resilience last? And how well placed are we in Britain to prosper? Things are certainly a lot better than we might think looking at the crash in share prices from their peak two-and-a-half years ago. Stock market indices are down by nearly fifty per cent. And that’s inevitably raised the spectre of the Thirties, the last time there was such a crash in equity values. “We are suffering just now,” wrote John Maynard Keynes in the midst of the slump, “from a bad attack of economic pessimism.” It was due, he said, to the “growing pains of over-rapid changes, from the painfulness of readjustment between one economic period and another.” Maybe we’re in for a repeat bout. Does Nick Crafts, one of our most eminent economic historians, think we should be haunted by the scary parallels with the past? CRAFTS The sorts of things that were involved in the collapse seventy years ago were failure to spot what was happening to the banking system and to intervene quickly enough and to be trapped in the gold standard for far too long. We have a floating exchange rate regime now between the major parts of the world and I think the authorities are much more aware of potential weaknesses in banking systems. In that context, generally monetary policy has been relaxed in the last year or two, there’s a scope to relax it slightly more and I think that probably would happen if need be. COYLE We’re in the third year of what the cognoscenti call a bear market, the misleadingly cuddly description of persistently falling share prices. So perhaps low interest rates are helping keep the financial system safely lubricated, avoiding that 1930s mistake of letting the flows dry up. The stock market can be an indicator of what’s in store for the economy because investors set share prices by looking forward to future business prospects. But it’s easy to exaggerate the link between the financial markets and the real economy of jobs and investment, of moving house and shopping in the supermarket. In fact, the stock market has predicted eleven of the past four recessions. In other words, a slump in share prices is more likely to be followed by an economic recovery than by a recession. For Danny Quah, what’s important is the underlying strength of the economy rather than the financial gyrations. QUAH Financial markets are volatile - they can change by as much as six per cent from day to day. The real economy does not do that, you know. What stronger evidence do you need that there’s a disconnect between the financial and real economy? On average, the stock market over the last twenty years has done pretty much what it has done for the last two hundred years. So, we see these volatile movements but a lot of that we should just discount - we should just put out of our mind. People are in the stock market for the long term, the stock market’s going to continue to plough on ahead, these changes are not things that are going to derail a real recovery - a real improvement in economic performance. COYLE Enough people are long term investors to uncouple any tight link between share price performance and growth or unemployment. That disconnect, as Danny Quah calls it, is key. The markets may look ahead but do they see what’s actually there? CLIFFE The stock markets often give false signals because forecasts of the future are always distinctly unreliable and sometimes markets get misled. COYLE Mark Cliffe at ING Markets. When reality doesn’t live up to expectations, disappointment sets in. CLIFFE It’s a sort mirror image of the exuberance we had in the spring of 2000 because if you go back to that time, of course, people were saying this was a boom without parallel – this was an unprecedented boom that would never end. Now we’re hearing that this is a recession that’s never going to end and the equity markets are not going to recover for a decade or more. So I think we should place about as much weight on that view as we did on the preceding view back in 2000. COYLE The predictability of the opposite and equal reaction is little comfort to investors nursing losses. But it’s a reminder of some basics. Share prices measure the value in today’s money of all the expected future earnings of a company. The reverse compound arithmetic that translates tomorrow’s values into today’s means a small shift in the economy’s expected future growth rate should trigger a large movement in the stock market. So a one per cent cut in the likely growth of earnings translates into a twenty-five per cent drop in shares. We shouldn’t explain away such big share price changes as nothing more than mood swings, although psychology has certainly played a part too. But whatever the irrational component in the stock market’s plunge, there is a connection with the everyday economy. Robert Shiller, professor of economics at Yale University, is the author of Irrational Exuberance. His best-seller published in 2000 warned presciently that over-valued stock markets would crash. Investors are billions poorer than they were in the spring of that year. Even where they’ve only made losses on paper that will affect their economic behaviour. SHILLER The stock market is more important than it used to be psychologically because people are so much more attuned to it. It has become, for many people, an everyday activity to check the market. Now because we’re thinking so much more about the market, I think, that this so-called “wealth effect” – which is the effect of the stock market on our decisions to spend – might arguably be stronger now than it was in the past. But it’s not just a simple “wealth effect” – which is that you spend more because you have more wealth – I think the stock market value affects our whole view of the world. MARTIN The large fall in savings is concentrated amongst those – the richer part of the population who own most of the stocks but it’s also the case that they also account for a great deal of the spending so as they rein back it’s not the case that the only thing which is affected is the consumption of beluga caviar or champagne: it does have a wider impact upon the economy. COYLE Bill Martin, chief economist at UBS Global Asset Management in the City. MARTIN As we’ve seen, the rate of unemployment in the United States is rising and that gradually may undermine confidence and cause other people, who were less benefited by the stock market bubble, also to think again about their rate of saving. They may be wanting to save more for precautionary reasons, for example. And so, what was concentrated in one part of the economy will, I think, inevitably spread elsewhere. COYLE It may be tougher for rich investors but, as Bill Martin warns, their loss of nerve could turn contagious. There are many more investors now than in the recent past – nearly eighty million in the United States where mutual funds are an easy way to put savings into the stock market. And, of course, most of us in Britain are investors through our pension funds. Anyone about to retire could be disappointed in their pension, even though the fund managers try to insulate pensioners from the worst excesses of volatile stock markets. So the wealth effects of the dramatic decline in share prices could yet turn out to be profound. That’s how the market could damage the real economy. Even more pessimistically, Robert Shiller thinks investors still have to make a big psychological adjustment to the end of the 1990s’ bubble. SHILLER All of this decline in the market has not shaken their faith because the official interpretation is, “It’s just a correction. It always goes up. This is a test of your patience.” And people, while they’re a little bit annoyed because it’s taken so long, they haven’t changed that view. So they’re still expecting the market to do wonders in the coming years. But I think another scenario is quite a bit more likely and that is that the market bounces up and down and up and down and no historic turning point is in the near horizon. COYLE But isn’t that the pattern of history: that we do have bear markets and bull markets? Or is that just putting too much pressure on the data? Do they not actually show that? SHILLER They don’t show that bull markets, like we saw from 1982 to 2000, are common. There’s been only two of them – the Twenties and the Nineties. If you take the US stock market from 1871 to 1991 and compute what the average annual growth rate of stock prices corrected for inflation has been, it’s been two per cent a year. Of course, then it’ll pay higher dividends so over that whole period you’ve got a return of something like seven per cent, but it has not been anything like the 1990s. But people still have this view of the world because they’ve seen it do this through their entire life – that the market has just gone up and up. They want to know when is that starting again and that’s the wrong question to ask. COYLE Wrong because the world’s a duller place in reality than it seemed in the roaring Nineties. You’d better have enjoyed it while it lasted! Adjusting to a world where stock market wealth no longer increases effortlessly poses an even bigger danger than having to crimp our spending habits, whether they run to caviar and champagne or beer and curry. Many people – and companies too – felt wealthy enough, as the century turned, to run up unprecedented levels of debt. In the telecommunications industry, it’s already led to defaults and bankruptcies. Peter Warburton is a consultant to Ruffer Investments and the author of Debt and Delusion. For him, the debt built on the foundation of such worthless assets as dot com shares is the biggest danger to continuing prosperity. A huge danger, in fact, because it’s not just bank loans but all kinds of financial arrangements – such as corporate bonds and derivatives – which have spread to the furthest capillaries of the financial system. WARBURTON It is far too soon to say that this economy is resilient of its own accord rather than resilient contingent on the availability of cheap borrowing. And clearly there is a real danger when lots of credit arrangements are going sour – and obviously consumer credit in America is suffering the highest rate of delinquency for at least fifteen years, probably for much longer – there’s a very real possibility that the availability of credit is going to disappear from large swathes of borrowers both in the corporate sector and in the personal sector. And, therefore, those whose lifestyles have been contingent on access to new credit and to be able to roll over existing debts - those facilities will either become too expensive to service or they will become unavailable altogether. And that could very well prompt a very sharp dislocation in the economy. COYLE Ouch! Sounds painful. But how painful? As Peter Warburton hints, it’s hard to tell how much debt is too much. It all depends whether we as borrowers are right to feel confident. Getting the policy right is vital because the debt danger is more than purely theoretical. The Japanese economy – the world’s second largest – has been stagnant for all of the past decade, striving to escape from the quicksand of debts created during its late 1980s financial bubble. That’s why bankers like Mark Cliffe at ING Markets are hoping, for once, that borrowers don’t tighten their belts too much. CLIFFE I’m much more worried about the asset side of the balance sheet than I am about the debt side of the balance sheet because if the assets are doing okay and asset values are not plunging then the debts, I think, will probably look after themselves. It’s not the level of debt that will create the problem. It could make it worse if asset prices continue to plunge and profits continue to plunge. So I think it’s the asset side of the balance sheet that the companies and indeed the policy makers will have to work on over the next few months. COYLE As long as corporate and personal debtors can repay their loans, there won’t be a widespread problem. Stabilising the financial markets would help plump up wealth levels back into a comfortable cushion to support the high levels of debt. And, as long as it’s comfortable enough, defaults shouldn’t happen. A big mortgage isn’t a bad thing if your property keeps its value and you can meet the monthly payments. Is this why the financial authorities have been so eager to reassure investors in the stock market by cutting interest rates quickly and keeping them very low? CLIFFE I think that’s probably right. Of course, the Federal Reserve in the US has been examining the experience of Japan to get some kind of lead on how to respond to a deflationary situation which, of course, the Japanese have been struggling with for many years now and I think that indicates a basic asymmetry in monetary policy. In other words, the threat of deflation at this point is far more serious than the threat of inflation. And it implies a readiness to cut interest rates rather faster than perhaps conventional economic analysis would suggest. COYLE And do you read into the fact that the Fed has kept interest rates this low any great concern on their part about this problem? CLIFFE Yes, I do. I don’t think they sort of admit this publicly because, of course, they’re also in the business of trying to talk up the markets as well. But the very fact that interest rates are as low as they are already, I think, is an indication of just how concerned they are about equity prices. COYLE The rapid policy reaction should stabilise share prices. Peter Warburton also believes the US Federal Reserve and other central banks are riding to the rescue of the stock market. But, in line with his darker interpretation of events, he thinks they have to because they let the financial bubble get out of control in the first place. WARBURTON Clearly the identification of personal wealth and well being acquired through the financial markets have become a very significant factor in the popularity of governments and the seeming success of economic development. And I think once that connection was established then suddenly central banks acquired an unwritten mandate to prevent anything really serious happening to people’s financial wealth. COYLE For the sake of economic growth, the market wasn’t allowed to collapse. Safeguarding financial stability must have seemed like simple prudence to the authorities. Yet Peter Warburton’s probably right to predict that past debts will at least limit future spending demand by companies and consumers. So is there any scope for optimism that the American economy can still achieve solid growth? The hope lies in the gains in productivity and efficiency recorded by many companies during the boom, making the current downturn one of those painful periods of adjustment Keynes described. It’s difficult to get a clear picture through the clouds of new economy hype and the dust of corporate scandal. And, as we saw just last week, the official productivity figures are definitely subject to revision. But despite the downturn, across the economy corporations have a rich pipeline of new products and services and they’re still increasing their spending on new technologies. How promising does it look to someone at the heart of the current financial market turmoil, like Bill Martin at UBS? MARTIN My best guess is that we have seen a sea-change in productivity growth in the United States after a prolonged period, really, from the early Seventies until the mid- Nineties when productivity growth was really very slow. And the cause of the change, I think, is principally due to the increased importance of information technology in the economy and also after the mid-Nineties, a sharp improvement in the efficiency with which IT, particularly semi-conductors, were produced. Now, some of those forces may diminish but the increase share of IT in the economy is not likely to diminish rapidly. Indeed, it could continue to rise. And, for that reason, I would suspect that productivity gains will remain strong though maybe not quite as strong as they were in the five or six years after the mid-Nineties. COYLE Strong productivity growth would be just the right medicine, bringing higher profits and therefore higher share prices. From a cautious City economist these claims sound very encouraging – don’t they? SHILLER I find them crashingly unconvincing. I think that people who make those arguments have not come to appreciate the technological innovations of the past. COYLE Robert Shiller. SHILLER These people are saying that the growth rate of our economy will be higher than it was over earlier epics of human history when other innovations like the railroad, the automobile, electricity, computers – there’s so many of them – so this human progress has been going on producing growth over the last century. I have never seen any convincing study arguing that it should be higher now. I mean, I love the internet too, but I don’t know how it’s different from electrification in its potential for promoting growth. COYLE But I suppose the argument is: growth could be higher compared to the quite recent past – the Seventies and Eighties – when it was very subdued? SHILLER Well, that was when the computer was making an explosive progress! Maybe. I mean, you could extrapolate recent gains in productivity and say it might go for a while. But then they were not as high as they were in the Fifties and Sixties. COYLE For all his gloom, Robert Shiller’s right that looking at the past is a good way of keeping our enthusiasm in proportion. Nick Crafts, in his historical research at the LSE, has calculated the recent productivity record of the United States. What do the figures suggest? CRAFTS My suspicion is that trend growth in productivity has gone up, though rather less than one per cent a year, but enough to be quite significant in historical terms. COYLE Can you give us an idea of what kind of scale of change that is? How does it affect people’s lives? CRAFTS If we’re talking about something which will allow the economy to grow at half or little more than half-a- percent a year faster into the medium to long term, then we’re talking about something which cumulates over time to a much bigger and more prosperous economy. We can add it up over fifteen, twenty years and we start to find that the economy’s ten, fifteen per cent larger than it otherwise would have been. COYLE Ten to fifteen per cent of eight trillion dollars, which was the size of the US economy last year, sounds like serious money. In fact, it would be just like adding on Canada. It’s the magic of compound arithmetic again. And if those figures are right, they’ll point to a brighter verdict on share prices too. Stock market exuberance can be rational after all. Danny Quah is optimistic. QUAH Higher productivity growth will show up in higher profit streams, higher earnings. The value of a company – the market capitalisation of a company with well-functioning markets – is a reflection of the stream of future earnings, the stream of future profitabilities of the company. If the underlying growth rate is higher, then the market capitalisation, the stock market value of a company, should correspondingly be higher as well for companies operating in this environment. COYLE More productive companies will grow faster and be able to pay their investors higher dividends. This is uncertain, of course: potential rewards to be set against the certainty of the debt burden. But Mark Cliffe at ING Markets sees that potential as eye-catching – not least in Europe, for all that the US boom and recession have dominated the world economy for the past decade. CLIFFE One of the really encouraging things that we have seen is that not only is productivity performing better than it was in the boom period, it’s actually performing better in the midst of this economic downturn. So that the gap between actual productivity growth and what you might have predicted on the basis of previous historical relationships is getting wider still. The history of technological innovation will also tell you that it does take a while for this to spread around the world economy and that is really the next phase that I’d be looking for over the next decade as this technology starts to be implemented in full around the world. COYLE We’re sharing the pain of America’s stock market crash, but we could also enjoy the gains of the sea- change in US productivity. As it’s already the richest and most productive economy in the world, America has usually grown more slowly than the other advanced industrial countries. Better still for the tortoises in the productivity stakes, says Nick Crafts at the LSE, as we return to a more normal pattern. CRAFTS The late 1990s really are exceptional in the sense that up until the mid 1990s, the general picture is one where Europeans have higher productivity growth than the United States. I suspect that what we’ll see is a similar pattern emerge in the early twenty-first century. The US will be leading this new technology and then the Europeans will catch up. We can start to see some signs of that in the greater use of information communications technology-type capital by the main European countries definitely accelerating in the second half of the Nineties. So, it’s not impossible by any means that relative productivity performance will be reversed and we’ll go back to a situation more like that of the 1980s. COYLE European companies should be able to catch up to the higher productivity levels of their American competitors if they’ve made genuine improvements in efficiency. That includes British firms whose productivity is notoriously low in comparison with the United States. This is a chance for us to narrow the gap. Surely we can do that anyway, whatever tides of fortune buffet the US meanwhile? Despite America’s size, its trading influence and the reach of its multinationals, the European Union does most of its trade internally, not across the Atlantic. So won’t we avoid serious economic disruption? Maybe not. The dollar affects exporters everywhere. And a deficit-financed US military build-up in the Middle East will have economic as well as political repercussions for the whole world. Robert Brenner is professor of history at the University of California in Los Angeles and author of the new book, The Boom and the Bubble. BRENNER Oh, I think it is anything but an American drama! The economic developments in the United States for good or evil are absolutely essential to international prosperity. To the extent the world economy was able to emerge from its stagnation and to boom in the second half of the Nineties – this depended entirely on the growth of the American market. Now, even the falling dollar is going to have huge repercussions for the rest of the world especially because policy, under the new liberal regime over the last twenty years, has focused so much of the growth of the world economy on exports. Should the US market slow down, begin to contract – it’s hard to think of a region of the world economy that could fail to be seriously hurt. COYLE Despite the staggering potential of productivity growth, managing the world economy through this downturn is going to be a stiff challenge. For now, the British economy is fairly buoyant, but although house prices are ballooning, manufacturing industry, it seems, is sinking and spluttering. Turbulence from across the ocean sounds pretty unwelcome. Bill Martin, the voice of caution from the City. MARTIN It is bad news. Probably of the major economies the British economy is not the most vulnerable. But if there was a period in which, say, the American economy was growing at two per cent rather than its potential rate which is no doubt three or more, it clearly has a generally rather depressing effect upon the outlook for world activity. I think, therefore, that British policy makers can offset some of the impact that one would get from a slow period of growth in the United States by judicious use of interest rates and a fiscal policy – after all, the Chancellor, Gordon Brown, is engaged in an expansion of the budget deficit and he could conceivably think of doing more. But there is a limit to the extent to which one can offset the depressive waves possibly coming across the Atlantic, but I think that we can at least take out the peaks of those waves. COYLE Are we really in for the economic version of the British summer? Keynes concluded in 1930 that the economic pessimism of his day was overdone. He told his readers their grandchildren would be eight times better off by the early twenty-first century. He was almost exactly right. Modern economies grow nearly all the time, thanks to continual innovation and investment. Year after year this adds up to an increase in prosperity that staggers the imagination – even without a new productivity miracle and all the more so with one. Of course, there are recessions, but they’re aberrations. As for serious global depressions, we’ve only had the one in modern times. We all focus on the stock market. Let’s face it, it’s where the excitement is. But it’s a fickle guide to the future – and even less likely to be right about an economic slump than it was about a boom in the first place. It’s time for us to indulge in a little rational economic optimism. 1