Reeling Stock Markets

http://business.guardian.co.uk/comment/story/0,,2023410,00.html

The current panic on the world’s markets is indicative of more than just the madness of crowds, writes Larry Elliott

Wednesday February 28, 2007
Guardian Unlimited

Predictably, the crash in global share prices is being shrugged off as a mere blip. The fact that Shanghai fell by 9% in a day and Wall Street had its biggest one-day fall since 9/11 doesn’t mean we need to be getting the soup kitchens ready for the return of the Great Depression. Fair enough: it would be utterly daft to assume from a single day’s losses, even when they are hefty, that the end is nigh for global capitalism.

On the other hand, however, the way in which the sudden plunge has been dismissed as simply “one of those things” is also massively complacent. Here’s what has happened.

Firstly, financial liberalisation has meant punters can invest what they like, where they like. There are few capital controls to impede the speculative flows. Secondly, central banks have helped to ramp up the level of speculation by cutting interest rates and thereby pumping money into the markets. That’s a bit like a casino handing out free chips.
Finally, the apparently benign state of the global economy has given investors the misguided impression that the markets are a one-way bet. And this applies to more than just the traditional investments: a period of strong global growth and low inflation has persuaded investors that even punts that look, to the uninitiated, like highly dodgy propositions – such as developing-country bonds or higher-risk mortgages in the US – are actually as safe as houses.
But add a few clouds to the clear blue sky and the outlook looks a bit less rosy. Central banks have started to raise interest rates as some of the inflation in asset markets has seeped out into the general economy.
In the US, dearer borrowing costs have killed off the housing boom, and there are clear signs that the economy is slowing down. China and other Asian countries rely on exports to the US for their impressive growth rates, and anything that imperils the ability of Americans to be the consumers of last report has knock-on effects across the rest of the world.
As I say, none of this means a slump is either imminent or inevitable. But there is something inherently unstable about a global economy where growth relies so heavily on ever higher levels of debt.
In the US, cheap money helped haul the economy clear of recession in the early 1990s and prompted the dotcom bubble. When that bubble popped, the Federal Reserve responded by pumping up another bubble, in the housing market. Presumably it will respond to the downturn in exactly the same way, but all the time saddling the US consumer with a more onerous debt burden.
You may conclude from all this that the current state of global financial markets has all the hallmarks of the madness of crowds, and I would agree with you. But be warned: Keynes once said that markets can remain irrational for longer than the average investor can remain solvent