The household wealth effect on personal consumption expenditures has been documented, but stock prices have a statistically highly significant impact on private capital investment as well. Such analyses suggest that much of the recent decline in global economic activity can be associated directly or indirectly with declining equity values. (?!)

By Alan Greenspan

Published: March 30 2009 03:00 | Last updated: March 30 2009 03:00

Global economic policymakers are currently confronted with their most daunting challenge since the 1930s. There is considerable fear in the marketplace that the unprecedented set of stimulus programmes and efforts to recapitalise banks with sovereign credits will fall short of success. It is thus useful to contemplate alternatives to that distressing outcome.

Over the past two centuries, global capitalism has experienced similar crises and, up until now, has always recovered and proceeded to achieve ever higher levels of material prosperity. What would today's world look like if, instead of the vast government policy efforts to stem the onset of crisis, we had allowed market mechanisms and automatic stabilisers, currently built into most of our economies, to function without any additional assistance? Counterfactual scenarios are highly problematic to say the least. But there are intriguing possibilities that offer comfort that, if all else fails, the global economy is not on a track towards years of stagnation or worse.

In one credible scenario, behind the unprecedented loss of wealth during the last year and a half, lie the seeds of recovery. Stock markets across the globe have to be close to a turning point. Even if a stock market recovery is quite modest, as I suspect it will be, the turnround may well have large (and positive) economic consequences.

For a few months before the August 2007 disruption, the crisis was wholly financial. The world's non-financial sector balance sheets and cash flows were in good shape. But the contagion from the crisis in finance took hold in the autumn of 2007. Global stock prices peaked at the end of October and then progressively declined for nearly a year into the Lehman crisis. Global losses in publicly traded corporate equities up to that point were $16,000bn (€12,000bn, £11,000bn). Losses more than doubled in the 10 weeks following the Lehman default, bringing cumulative global losses to almost $35,000bn, a decline in stock market value of more than 50 per cent and an effective doubling of the degree of corporate leverage. Added to that are thousands of billions of dollars of losses of equity in homes and losses of non-listed corporate and unincorporated businesses that could easily bring the aggregate equity loss to well over $40,000bn, a staggering two-thirds of last year's global gross domestic product.

This combined loss has been critically important in the disabling of global finance because equity capital serves as the fundamental support for all corporate and mortgage debt and their derivatives. These assets are the collateral that powers global intermediation, the process that directs a nation's saving into the types of productive investment that fosters growth.

I find it useful to think of the world economy's equity capital in the context of the global consolidated balance sheet. All debt (public and private) and derivatives cancel out, leaving intellectual and physical assets at market value on the left-hand side of the balance sheet and the market value of equity on the right-hand side. Changes in equity values result in equal changes on both sides of the balance sheet. Debt and derivatives are best seen as a grossing up, reflecting the degree of intermediation or leverage.

The consolidated global equity is also, by construction, the sum of the separate but additive equities of all individual corporations, other businesses, households and governments. At some point, global stock prices will bottom out and rise. A rise in global private sector equity will tend to raise the net worth (at market prices) of virtually all business entities. In a bull market, the vast majority of stock prices rise. Newly created equity tends to be arbitraged across global businesses. In the current environment, new equity will open up frozen markets and provide capital across the globe to companies in general, and banks in particular. Greater equity, after addressing the shortage of bank net worth, will support more bank lending than currently available, enhance the market value of collateral (debt as well as equity), and could reopen moribund debt markets. In short, liquidity should re-emerge and solvency fears recede. Restoration of normal global lending could be as effective a stimulus as any fiscal programme of which I am aware.

Widespread capital gains will add equity to balance sheets, but aside from increasing liquidity and decreasing insolvency, they do not in themselves raise economic activity. The fact that claims on business entities are, in effect, purchasing power, does. Most automotive dealers, for example, being compensated for the inconvenience, would presumably accept shares of stock as payment for a car. We see this process more generally in the so-called wealth effect, where the creation of capital gains augments spending and gross domestic product, whereas capital losses lower spending.

We too often think of fluctuations in stock prices in terms of "paper" profits and losses that are somehow not connected to the real world. But the evaporation of the value of those "paper claims" over the past 18 months has had a profoundly deflationary impact on global economic activity. Failures of intermediation have hobbled many economies over the decades, most conspicuously Japan in the 1990s. The household wealth effect on personal consumption expenditures has been documented, but stock prices have a statistically highly significant impact on private capital investment as well. Such analyses suggest that much of the recent decline in global economic activity can be associated directly or indirectly with declining equity values.

Of course, it is not simple to disentangle the complex sequence of cause and effect between change in the market value of assets and economic activity. If stock prices were wholly reflective of changes in economic variables, movements in asset prices could be modelled as endogenous and given little attention. But they are not. A significant part of stock price dynamics is driven by the innate human propensity to swing intermittently between euphoria and fear, which, while heavily influenced by economic events, nonetheless has a partial life of its own. In my experience, such episodes are often not mere forecasts of future business activity, but a key cause of it.

Stock prices are governed through most of the business cycle by profit expectations and economic activity. They appear, however, to become increasingly independent of that activity at turning points. It is this property that makes them a leading indicator, which is the conclusion of most business cycle analysts.

The substitution of sovereign credit for private credit has helped to fend off some of the extremes of the solvency crisis. However, when we look back on this period, I very much suspect that the force that will be seen to have been most instrumental to global economic recovery will be a partial reversal of the $35,000bn global loss in corporate equity values that has so devastated financial intermediation. A recovery of the equity market, driven largely by a receding of fear, may well be a seminal turning point of the crisis.

The key issue is when. Certainly by any historical measure, world stock prices are cheap, even after the recent run-up. But as history also counsels, they may or may not get a lot cheaper before they decisively return to more normal levels. What is undeniable is that stock market prices today are being suppressed by a degree of fear not experienced since the early 20th century (1907 and 1932 come to mind). But history tells us that there is a limit to how deep, and for how long, fear can paralyse market participants. The pace of economic deterioration cannot persist indefinitely.

It is the rate of decline of product, labour and financial markets that generates much of the uncertainty that, in turn, fuels fear. To an employed person, it is the rate of job cuts, more than the level of unemployment, that fosters job insecurity and the economic responses that go with it. The current pace of deterioration is bound to slow and with it there should come a lessening of the level of fear. One cause of fear is uncertainty. This uncertainty is reflected in the spread of corporate bond yields over US treasuries. The spread has historically exhibited consistent upside and downside limits clearly indicated by data going back to the 1870s. Today we are at an outer extreme of historic credit risk.

As the level of fear recedes, stock market values will rise. Even if we recover only half of the $35,000bn global equity losses, the quantity of newly created equity value and the additional debt it can support are important sources of funding for banks. As almost everyone is beginning to recognise, restoring a viable degree of financial intermediation is the key to recovery. Failure to do so will significantly reduce any positive impact from a fiscal stimulus.

The writer is the former chairman of the US Federal Reserve.

Copyright The Financial Times Limited 2009

Equities show us the way to a recovery