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29 October 1997

Stock Market Rollercoaster: Is this the big one?

Phil Mullan reflects on a week of stock market upheaval

The timing could not have been more apposite. Exactly ten years after the 1987 stock market crash, the commentators were poised, their lexicon of dramatic headlines at the ready: 'bull market over', 'markets in turmoil', 'markets braced for nose-dive', 'markets plunge', 'panic as markets crash'. For over a week, ever since the Hong Kong financial markets started to fall, speculation has been rife. That familiar, but largely fictitious, bogey of 'globalisation' made its appearance. Would Hong Kong be the catalyst for a shockwave spreading through the global markets causing a meltdown of 1929 proportions? Is the market economy on the ropes again?

After a jittery end to last week in many western equity markets, Wall Street's performance on Monday seemed to vindicate the doom-sayers. The Dow Jones industrial average fell over 550 points, or 7.2 per cent, logging its biggest point decline ever. The drop triggered an early shutdown to trading on the US stock markets, the first time that has happened since 'circuit breakers' were instituted in the aftermath of the 1987 market crash. Tuesday began with European bourses following the US lead, registering early falls of 7 to 10 per cent. Professor JK Galbraith, one of the few living economists to have experienced the 1929 crash, was wheeled out to remind us that market collapses are an inevitable feature of capitalist markets. What goes must come down with a thud. It has all been the same, he claimed, since the great tulip crash of the seventeenth century. A crash is 'a natural feature of the system. It has been for 300 years and more', he said.

So what is going on? Will the stock market falls bring about a significant downturn in the real economy? Does it mark the return of the bear market after the great bull market of the 1980s and 1990s? Is it, even, the beginning of the end for capitalism? The answer to all these questions must be an emphatic no. Stock market instability on this scale is certainly indicative of the underlying weakness of some economic fundamentals. But it is not a precursor to a 1930s style economic collapse. Happenings in the financial economy are always secondary, in cause and significance, to what is happening in the real world of capitalist production, whether we are talking about the 1930s, the 1980s or today.

Financial crises can never, on their own, create real social crises. Most commentators have been too preoccupied with PE ratios, yield curves, and anxiety about the shadowy speculators to see what is different today. The missing ingredient compared to the 1930s is the absence of genuine social (or, to use a passe term, class), opposition to capitalism. It was this force and its ramifications, both domestically and internationally, which precipitated the real turmoil of the 1930s, not merely the 1929 collapse in share prices. Without the pressure of this social challenge, the free market system will always be able to muddle through. That is what we can expect today, even more so than was the case in the late 1980s.

Nor do stock markets today signify much about movements in the underlying economy. The state of stock markets express something about the state of the real economy. But equity price movements, in direct proportion, are neither caused by nor can impact significantly upon, movements in the real economy. The relationship between the financial and real economies is much more elastic than that these days.

We can also anticipate the financial markets will stabilise at some point in the not too distant future. (So if you are one of the 17 million private shareholders in Britain, heed the number one rule for investors: don't sell in a falling market.) The 20 per cent plus falls in major stock markets in October 1987 are still remembered, especially on anniversaries, as a serious crash. However, looking at the graphs of the last fifteen years of bull markets in Britain and the US, 1987 represents little more than a blip in an upward trend in equity prices. Even at the price lows of recent days, most share prices in Britain and the US were still well up on where they stood at the start of this year. Monday's Wall Street fall was a record in points terms, but did not even make the top ten worst days in percentage terms, so far has the index risen during the bull years.

The financial markets, however, do tell us something about the state of the real economy. But it is the opposite of what most of the analysts are saying. The received wisdom about these movements on the world's stock markets is that the economic fundamentals are weaker than thought in East Asia, and stronger than doubted in the west. The reverse is true.

The source of rising stock markets around the world is the excess of liquidity in the west. This is the by-product of years of weak economic activity. In the hyped US discussion about a 'new era' of economics, it is always overlooked that a buoyant IT sector in the US is not the same as a booming western, or even US, economy.

Profits are still being realised but what is to be done with them then? The abundance of spare cash in the advanced economies is primarily the result of a shortage of spheres for productive investment and a loss of nerve by capitalist institutions often unwilling to seize those opportunities where they do arise. Greater personal savings by people apprehensive about their living standards in the future, and especially during their old age, have added to the pool of cash available, but the real issue is what happens to all this money once it is in the coffers of the financial institutions. As it is not primarily used for investment in expanding productive capital at home, there are two alternatives. It could be kept in cash deposits in banks; but real interest rates are not high enough to make that very attractive. So most is used for making investments in financial assets such as equities and bonds.

Some of this has been attracted into the markets of the only really booming region of the world: the markets of East Asia, the so-called tiger economies - Hong Kong, Singapore, South Korea and Taiwan - and the would-be tigers like Thailand, Malaysia, Indonesia and the Philippines. When there is little else going on in the world economy, this one region becomes recipient to a disproportionate amount of the funds available. Consistent with the coolness towards direct productive investment (though this is not negligible), most of it takes the form of portfolio and other short-term capital flows.

East Asia comprises genuinely dynamic economies, but the aspirant tigers, especially, are still too small and unevenly developed to cope with this flood of financial capital from overseas. The fuel of these foreign capital flows has stimulated much speculative investment in financial paper and property, imbalancing these economies. Their financial asset prices have risen much faster than the underlying economies warranted, creating an unstable financial pack of cards. The market falls in the past few months are the result. It would be more appropriate to conclude that the problem is not that their real productive economies have grown too fast, but not fast enough. The ultimate cause for their market crashes is not domestic at all. It is the circumstances back in the west that have produced the mass of excess financial funds, which have flooded in to overwhelm them.

It is the same relative weakness of economic activity in the developed countries that provides the liquidity sustaining the bull equity markets back in the US and Europe. The repatriation of some western capital from SE Asia, unnerved by financial turmoil there, will only boost this mass of liquidity. The liquidity must still go somewhere. Hence the shift into other forms of portfolio investment such as bonds, and the return to buying equities before too long. The Wall Street Journal Interactive Edition on Tuesday 28 October described this latter tendency: 'But after the big drops Monday and early Tuesday, buyers were lured back into US stocks. For years, dating back to the 1987 market crash, investors have been richly rewarded for buying stocks when prices take a tumble. This "buy the dips" mentality has helped prices to recover quickly each time the market has made a drop.'

The stock market rollercoaster turmoil does not herald either an economic or a social crisis, but it is a sign of the deficiencies and weakness of the underlying market system.

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