An asset to the economy- (22.03.02)
How important are asset values to the current state of the US and UK economy? To what extent does a recovery depend on the strength of the stock exchange and the housing market?
These questions were posed recently by John Calverley, Chief Economist of American Express Bank in an article in The International Economy. He argued that these two factors were dominant in determining economic performance and therefore monetary policy should be adjusted to reflect the impact that these two items have on the business cycle.
At first glance there is an obvious counter to this. Stock values and house prices are more indicators of the economic cycle rather than drivers of it, more so for house prices than stock values certainly. House prices tend to be driven by local economic issues, such as the job market. The local job market can be easily affected by even international factors, such as an imported recession from the US to the UK affecting the general economy and a knock on effect to local firms. Monetary policy tends to play a role in trying to even out and cushion the effect of external factors, outside the US economy at any rate.
One point in favour of asset prices is that historically there is strong evidence of them being related to interest rates. Low interest rates encourage investment in shares rather than cash or bonds, all other things being equal. Low cost of corporate borrowing should also boost corporate earnings, again supporting the stock market. The link between low interest rates and house prices is even more obvious. However interest rates cannot be used to fight a recession on their own through some mechanism that supports asset values. Low inflation is the key to this and therefore real interest rates rather than the headline rate may have some impact in the way that has been suggested. It would seem likely that in this time of low inflation asset values have become a more significant driver of economic growth than in the past. For instance in the 1970's oil was of more importance, in the 80's economic liberalisation, in the 60's full employment etc. Monetary policy itself could have little impact on these factors then in the same way it is unlikely a government could have a successful strategy on asset values now.
Another point made is that consumer confidence is driven largely by asset values. Again this is true to a certain extent but it is not the main factor in consumer confidence and therefore not a suitable focus for government economic policy. Consumer confidence is far more likely to be affected by the local labour market, which is dependent more on international economic factors and government policy at all levels than asset values directly.
The strength of asset values importance does come from the issue of deflationary economics. There is a risk with stable low interest and inflation rates that even during a managed slowdown in economic growth interest rates drop so low that a severe recession is caused directly by monetary policy adjustments. In the same way that governments used to walk a tightrope with high inflation and unsustainable growth they now take a risk with deflation. In deflation it is asset values that are the worst hit as cash securities become more certain holders of wealth. However, governments do still have demand side tools available to them (monetary policy is not everything after all?). Japan, the only recent example we have of a deflationary economy has more fundamental problems that are largely structural rather than monetary.