Back to Basics for the Market Value Pundits People Are Relying on Borrowing or a Rise in Their Asset Values to Sustain Demand

Article excerpt

IT WAS "phew!" time yesterday as bankers around the world began to contemplate what might have happened had the American authorities not cobbled together the deal to support John Meriwether's hedge fund last week.

We are not through the woods yet by any means, so expect a series of disturbing announcements from financial institutions about losses they have sustained.

Losses will stem not just from banks' loans to Long-Term Capital Management, but from the fact other banks were pursuing similar investment policies themselves. That is certainly what the plunge in bank share prices would lead us to expect.

It is impossible to say, but there may need to be rescues. However unless there is something truly dreadful still hidden, we should be prepared now for the focus of concern to change.

Expect two new developments: First, people will ponder why the US authorities had allowed the financial system to become so fragile. We all knew the Japanese banking system was fragile, but the American?

Secondly, they will become increasingly concerned about the way in which financial instability feeds back into the real economy.

On the first, there is not much that can be added at this stage. You cannot assess sensibly the regulatory failure until you know the full extent of the damage, and we won't for several months.

The second - the link between markets and the US economy - will become a live issue very fast. The US consumer has been the main engine of world growth through the last 12 months, even more than Europe, for continental European growth has been largely driven by exports, not home consumption.

Further, we cannot assume that continental Europe's recovery will be sustained. It will have to adapt to meet the demand of the one- size-fits- all monetary policy, which will be imposed by the new European Central Bank in three months. It would be surprising if the policy tended toward the looser end of the possible range.

So US consumers are very important. This week sees new information about the health of the economy in the shape of consumer confidence, the US purchasing managers survey, and unemployment. These are expected to be weak, though not in any dramatic way.

A fall in demand would be really troubling because consumers feel poorer as a result of the decline in the stock market.

PDFM have highlighted the link between share prices and demand. Bill Martin, the chief economist, points out that the private sector's cash flow has gone negative for the first time since the early 1950s. In other words, people are relying on borrowing, or the rise in value of their assets, to sustain demand.

What happens if share prices fall? Well, the possible impact is shown in the chart: a dip of about 5 per cent in GDP from where it would have been otherwise, with the trough about 18 months from the time of the collapse. …