The old 'I believe the recession is over - therefore it is' theory

Friday 25th January 2002

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The global economic downturn produced a widespread state of denial for quite some time before the shock set in. People did not want to believe that the boom was over.

Optimism was the theme of the day and one of its leading lights was none other than Alan Greenspan, chairman of the US Federal Reserve. Mr Greenspan was in a difficult position, however, because his every word is hung upon as if it bore the weight of oracular authority.

When it dawned that the US' New Economy really had hit the skids, delusion turned to disillusion. Mr Greenspan had to change his tune, and it is notable that in recent official testimony he was emphasising the downside risks still confronting the US economy.

His negative emphasis is intriguing in light of the tenor of market commentary from overseas sources. It could be that the markets are sick of hearing bad news and want to seize upon something of good cheer. In other words, the mood has shifted due to enervation and people are determined to feel better.

Whether they are factually right about the state of affairs prevailing, or whether accentuating the positive will effect change in the desired direction, poses an interesting question about the order of cause and effect prevailing between confidence and economic performance. And it was confidence that Mr Greenspan struggled to maintain before the weight of economic evidence gainsaid him.

We can say, however, that there is much more confidence about than there was a while ago, even if we except the unique perturbation due to the September 11 events. The terrorist bombings accelerated a gloomy emotional trend that was already gathering a life of its own.

The markets have moved on from the tragedy and in many cases restored former value. Now they are looking for evidence of the next upturn.

The principal theme of much commentary now is concerned with picking the timing of global rebound. The common view is that the US will turn around in the second or third calendar quarter of 2002. After that Europe should pull out of short-lived recession.

Japan we can forget about, perhaps, but Asia ex-Japan could recover reasonably quickly on restored demand from export markets.

Investors may already be discounting Asian rebound by what Deutsche Asset Management UK calls "stocks leveraged to global economic recovery." Of all the sharemarket regions it was Asia ex-Japan that put on the best show for end 2001 but then stocks of the region were in many cases coming off low bases.

Perhaps consensus has influence on market reality. If enough people believe the US will pick up around the middle of this year and that Europe will shortly after follow, maybe we will experience a self-fulfilling prophecy.

Morgan Stanley research on Europe stresses that business confidence indicators will be the real thing to watch. Europe's current downturn was triggered, so the argument goes, by deep cuts to capital expenditure in the wake of September 11. When businesses restore capital expenditure, it is claimed, the European upturn is on the way.

Referring to the Nobel Prize-winning work of the economists George Akerlof and Joseph Stiglitz, Morgan Stanley economists Eric Chaney and Christel Rendu de Lint argue that a mechanism exists for people to stage an economic recovery by rational response to imperfect information They wrote: "Corporate investment decisions are taken in a context of asymmetric information. In the midst of a downturn suppose your main competitor decides to upgrade its capex plans. You are entitled to guess that your competitor has information on demand you don't have yet. Even if this is not true, which is unknown, it is nevertheless rational to reconsider your own decisions.

"Once micro-economic decisions are aggregated it appears that the macro landscape can change rapidly as positive expectations begin to gain ground on negative ones, even though hard evidence of a genuine rebound is still fragile."

So that's how we will get our recovery - business will play follow-the-leader - and if enough believe that we are headed for Q2 or Q3 recovery this year then we are up and away. However, the same quotation might have bearing on how lemmings end up trying to swim the Atlantic.

And it is notable that all commentators, no matter how sanguine, are careful to append enough ifs and buts to avoid being caught out on the prediction. Maybe we should think of markets as working on the argument, "I believe it, therefore it is true." Which raises a question over the assumption of economic rationality where the blind are leading the sight-challenged.

The same aggregate decision pattern could be assumed to have significant influence over the point where sharemarkets again resume uptrend. And in retrospect, it could be said, fictionally perhaps, that the turning point represented when the market "realised" it should pay more for stocks.

In reality, much of the rise will be due to players jumping in after noticing that others are bidding up shares without knowing why these others are doing so. Conversely, on this logic lemmings should make great short-sellers.

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