Heed the fears of the financial markets

They understood the gravity of the 2008 crisis well before the Federal Reserve

Image of Lawrence Summers

Often markets are volatile at the end of a year and then settle down as a new year begins. Not this year. US and European markets closed lower on Friday after a very rough week despite a strong US jobs report. The week saw dramatic declines in China’s stock market and currency. Oil prices fell even in the face of major tension between Iran and Saudi Arabia.

A week when bad market news makes the front page raises two questions. How much should forecasters and policymakers look to speculative markets as indicators of future prospects? And how alarmed should they be about the prospect of a global slowdown?

Markets are more volatile than the fundamentals they seek to assess. Economist Paul Samuelson quipped 50 years ago, “the stock market has predicted nine of the last five recessions”.

Former Treasury secretary Robert Rubin was right when he would regularly reassure anxious politicos in the Clinton White House that “markets go up, markets go down” on days when a market move created either joy or anxiety. The best executives manage their companies with an eye to long-run profitability, not the daily stock price. And policymakers do best when they concentrate on strengthening economic fundamentals rather than on daily market fluctuations.

Still, since markets are constantly assessing the future and aggregate the views of a huge number of participants, they often give valuable warning when conditions change. Studies have shown that prediction markets do a better job of predicting elections than pollsters. Hollywood studios use such markets to judge the likely success of movies.

Policymakers who dismiss market moves as reflecting mere speculation often make a serious mistake. Markets understood the gravity of the 2008 crisis well before the Federal Reserve. They grasped the unsustainability of fixed exchange rates in the UK, Mexico and Brazil while the authorities were still in denial, and saw slowdown or recession well before forecasters in countless downturns. While markets do sometimes send false alarms and should not be slavishly followed, the conventional wisdom essentially never recognises gathering storms.

The Chinese financial services sector is about as large relative to gross domestic product as in Britain

The Economist reports that, looking across all major countries over the past several decades, there were 220 instances in which a year of positive growth was followed by one of contraction. Not once did International Monetary Fund forecasts anticipate the recession in the April of the growth year.

Signals should be taken seriously when they are long lasting and coming from many markets, as with current market indications that inflation will not reach target levels within a decade in the US, Europe or Japan. It is especially ominous when markets fail to rally on what should be good news.

It is conceivable that Chinese developments reflect market psychology and clumsy policy responses, and that the response of world markets is an example of transient contagion. But I doubt it.

Over the past year, about 20 per cent of China’s growth as reported in its official statistics has come from its financial services sector, which is now about as large relative to gross domestic product as in Britain, and Chinese debt levels are extraordinarily high. This is hardly a case of healthy or sustainable growth.

In recent years, China’s growth has come heavily from massive infrastructure investment; China poured more cement and concrete between 2011 and 2013 than the US did in the whole of the 20th century. This, too, is unsustainable. Even if it is replaced by domestic services, China’s contribution to demand for global commodities will fall.

The US economy grew robustly through the Asian financial crisis as the Fed brought down interest rates

Experience suggests that the best indicator of a country’s future economic prospects is the decisions its citizens make about keeping capital at home or exporting it abroad. The renminbi is under pressure because Chinese citizens are eager to move their money overseas. Were it not for the substantial recent depletion of China’s reserves, the renminbi would have fallen further.

Traditionally, international developments have had only a limited effect on the US and European economies because they could be offset by monetary policy actions. Thus, the US economy grew robustly through the Asian financial crisis as the Fed brought down interest rates. With rates essentially at zero in the industrial countries, however, this option is no longer available, and foreign economic problems are likely to have much more of a direct effect on economic performance.

Because of China’s scale, its potential volatility and the limited room for conventional monetary manoeuvres, the global risk to domestic economic performance in the US, Europe and many emerging markets is as great as at any time I can remember. Policymakers should hope for the best and plan for the worst.

The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary

Letter in response to this column:

Time for central bankers to remember small savers / From Jonathan P Kahn

Copyright The Financial Times Limited 2016. All rights reserved. You may share using our article tools. Please don't cut articles from FT.com and redistribute by email or post to the web.