We may well be through the worst
Share markets here and elsewhere nudging new "highs"; economic outlook mediocre. Is this a disconnect, or might the recovery in shares and other asset prices help sustain an increase in real demand?
This is a version of the question as to what extent asset prices reflect and shape the real economy. The answer must be both, but the balance between the two varies over time. For example, in spring 2008, shares worldwide were still pretty strong, giving no warning of horrors to come. They were a reflection of the widespread over-optimism at the top of the boom.
But since last summer share markets have perked up. You can interpret that in several ways. It may be a function of central bank pump-priming: the money has to go somewhere. It may be a growing disenchantment with the ultra-low yields available on sovereign debt, or at least the debt of so-called safe-haven countries. But it may be that share buyers are prepared to look through the probability of a dark spring and see a sunnier summer and autumn ahead.
Over the past three years the main markets have generally reflected the performance of the economies. You would expect the US and Germany to be at the top and Italy and Spain at the bottom.
Still, the shares recovery must have some impact on confidence and hence on demand. Here in the UK there is one direct effect: a rise in share prices reduces pension-fund deficits. For companies saddled with under-funded pension schemes this could be a life-saver. But there is a more general point. A rise in share prices will begin to open the rights issue route for companies seeking more capital. Taken as a whole the company sector is cash-rich, but there will be individual firms that are not and no company now wants to be beholden to its bankers.
So does the rise in share prices really add to demand? Marchel Alexandrovich at Jefferies International has looked at this and notes that an European Central Bank working paper in 2009 concluded that for the euro area, a 10% increase in net financial wealth increased consumption by 1.2%.
Since the Spanish share prices have risen by 20% since last summer you might expect that to give a 2.5% increase in consumption. But you have to be careful in making hard estimates from incomplete data. I don't think many of us feel more confident about spending more simply because our pensions look less insecure.
House prices, on the other hand, in the UK do seem to have an impact on consumption. There is the direct link in equity take-out. During the last housing boom, from 1997 to 2008, Britons supplemented their incomes by increasing their borrowings against their homes. Since then we have been steadily paying back that debt, saving money that might otherwise have been used to boost living standards. That ECB study calculated that changes in house prices in the euro area had a very small impact on consumption, but it may just be another way in which UK behaviour differs from our Continental cousins.
I suspect our relationship with property is much closer to that of Americans, and one of the really important issues this year will be whether rising confidence among US home-owners will offset concern about the handling of the fiscal deficit. We don't know what Congress will do but we know it will have a negative impact.
We don't know what will happen to the US housing market but we do know that the recovery evident since last summer will be sustained.
The market as a whole is now back to its level of 2003 and in only two cities, Detroit and Atlanta, are prices still lower than they were in 2000. In New York prices are 65% above 2000 level and in DC nearly double that. So while it is an uneven recovery the US market is returning to health.
My feeling here is that the US housing market will be the single most important determinant of how the world economy performs this year. It is not just that US consumption is 70% of the world's largest economy. The collapse of the world financial system began because of a collapse in US house prices. So a recovering US market not only helps global demand, it also reduces the property overhang depressing the banking system.
There are a host of things that can go wrong. These include mismanagement of the US fiscal situation, an economic collapse across southern Europe, Germany back in recession and so on.
Our own situation is precarious, for we have made only modest progress in controlling our deficit and are stuck, unable to reduce it further. More generally the rise in asset prices depends on the central banks continuing to pump up their respective economies.
But to focus on the fragility of the recovery in asset prices is to ignore the impact this recovery has on real confidence, real demand and hence on real growth.
We are not yet in a virtuous circle but we're no longer in a vicious one.