Economy dilemma for the US

Andrew Smithers12 April 2012

THE contrast between the stock market and the economy has amazed the US Press. Shares have fallen to last October's levels, while the economy has bounced back with unexpected vigour.

There is, however, no reason why shares should go up when the economy improves. If stock markets were rational, share prices would be far less volatile than they are. Since irrational sources of information cannot be fully trusted, it must be dangerous to take too much notice of share prices.

Nonetheless, stock markets give better predictions than you get tossing a coin. It is likely they make better forecasts than governments, which counts as moderate praise. The old joke is that the market has forecast seven of the last five recessions.

Wall Street did a good job two years ago. It peaked in March 2000, about a year before the US economy went into recession. Official forecasts did not do nearly as well. In fact, the US has not had much of a recession, except in terms of share prices and profits. These have been badly hit. In terms of output and employment, the US economy has, so far, escaped lightly.

This is obviously good news. But it is not cause for unalloyed rejoicing. The excesses of the bubble have not been expunged. Share prices and debt went over the top and major corrections to the level of both are still needed.

The stock market is still wildly overvalued and, at some stage, it will have to fall a lot. But value is only a weak guide to the way shares will move over the next year. If markets responded quickly to being overvalued we would never have bubbles. We can only get them because markets are difficult to forecast.

As share prices predict the economy, either investors have foresight or the market directly affects the economy. The way the US Nasdaq market tripled in value then collapsed makes it hard to have too much faith in investors' foresight. It therefore seems likely that the market influences the economy. The potential for a collapse in the market is worrying, as it suggests a poor economic outlook. Central bankers should therefore be prepared to do something if the market is weak. But in the US, the Federal Reserve has already cut interest rates so far that it can hardly cut them any more.

If the Fed had restrained the stock market before it went crazy it would not have a problem. It talked about stopping the bubble in 1996, but did not act and the error once made cannot be undone. So it must be praying the stock market remains healthy.

If equity markets and the economy slip, the US government may have to cut taxes again to revive economic fortunes. But the budget deficit is already rising faster than expected, so it may be difficult to get another tax cut through Congress.

www.smithers.co.uk

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