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Anatole Kaletsky: Economic view

My last article of every year looks back on the predictions I made in early January to shed some light on the economic and financial events of the previous 12 months. This tends to be a humbling experience, and this year it is even more so than usual.

While the world economy has not done nearly as badly as one might suppose from the financial turmoil that has dominated the headlines, it is still embarrassing to read the opening paragraph of my January outlook: “The period of greatest risk to the world economy is probably over. Interest rates may have a little way to rise in Europe and Japan. But the big rise in American rates, the doubling of oil prices and the inevitable correction in the US housing market have now happened. The biggest risks stem not from economics but from geopolitics. In most of the world, the mid-cycle slowdown is probably almost over and economic strength, rather than weakness, is likely to be the main surprise of 2007.” Only in the eurozone and Japan did I feel that consensus forecasts were a touch overoptimistic and the risks “were mainly on the downside”.

My financial predictions seemed even more egregious, since I ended by suggesting that “the bull markets in shares and property have every reason to continue, at least if we look at economics alone”. From today’s vantage point, in the midst of a banking crisis and housing slump that is spreading from America to Britain and Europe, these comments seem absurdly complacent.

But delving a little deeper into events suggests some justification for my apparent smugness and, more importantly, helps to explain why the past 12 months have proved so confusing to policymakers and so expensive to the banks that placed bets worth hundreds of billions of dollars on faulty financial judgments.

The fact is 2007 was very much a year of two halves. The first half unfolded more or less as I expected: in America, economic growth accelerated strongly after a slow first quarter, while Britain continued to enjoy a boom in economic activity, employment and, above all, housing. Europe and Japan, by contrast, started strongly but had slowed substantially by the middle of the year (see charts). Meanwhile, the emerging economies, especially in Asia, continued to enjoy the best economic conditions in their history. By midsummer the main concern among central bankers and investors was not a possible recession but the risk of global economic overheating. As a result, bond yields in America rose in early June to almost 5.5 per cent – their highest since the start of this global expansion. And analysts were almost unanimous in warning that the 25-year downtrend in long-term interest rates had been broken once and for all.

How different the world looked only a few weeks later, after the seizure suffered by inter-bank lending markets in August and the near-collapse of Northern Rock and a host of mortgage lenders in the US. Much has been written about these events and this is not the place to analyse them again. All I want to do is to put them into perspective by recalling two points that are easy to forget in the present panic. First, that economic growth had a lot of momentum behind it, especially in America and Asia but also in Britain, when the credit crisis struck in August. This is why expectations that the housing crisis would trigger a collapse of US consumption and employment have, so far, proved wide of the mark. Second, and this is easy to lose sight of, shares and house prices have ended this year considerably higher than they began, despite all the horror stories.

In America, the Dow Jones is 7 per cent higher than 12 months ago, having hit a record as recently as October 9. The FTSE 100 is up 5 per cent and Germany’s DAX has gained no less than 23 per cent and is near its all-time high, having fully recovered the losses of July and August. In Asia, stock markets are all far above levels before the credit crisis, with Hong Kong up 40 per cent on the year and Shanghai up 70 per cent. Only in Japan have asset prices substantially fallen, hardly surprising considering the renewed incompetence of the country’s economic and political management since Junichiro Koizumi resigned as prime minister in 2006.

Property markets, too, have faired much better that one might imagine, at least outside America. Last week, Nationwide said its house-price index fell for a second consecutive month in December and most analysts (including me) expect the market to get a lot worse. But it’s the strength, not weakness, of house prices in 2007 that is most remarkable. Nationwide’s figure is 5 per cent higher than a year ago, even after the recent falls. In London, where prices are falling more steeply than in the rest of the country – and are likely to fall faster in the year ahead – the average house price is still about 10 per cent up on the year.

So why do the official statistics differ so totally from the grim picture presented by financial markets and media comments, including mine?

There are three reasons: first, official statistics are, by definition, backward-looking and while it is unlikely that the next few months will see the widely predicted slump into recession, a much weaker period probably does lie ahead, especially outside the US. Second, aggregate statistics give no indication of the huge shifts in activity, employment and profitability between sectors and regions. US housing has suffered a steep decline, but this has been offset by very strong export growth. That, in turn, has reflected a shift in the world economy towards emerging markets, which now contribute almost 30 per cent of economic activity and much more to growth. Third, the haemorrhage suffered by the financial system in the mortgage bubble has so far done very little damage to the real economy of jobs, consumption and investment. But the banks cannot continue to lose at the rate they have since August without eventually weakening economic activity around the world.

The key question for the year ahead, therefore, is whether the banking crisis is almost over or whether investors and governments will allow the spiral of losses to accelerate until it drags the entire world economy into some kind of a black hole. My views, for what they are worth, about this and the other risks to the global economic outlook will appear here on January 14.