Testing the sharemarket barometer

It's time to consider that the stock market is no longer a reliable barometer of the direction of the economy. It now in fact follows the real economy, rather than predicts it.

Within this context the renewed wave of panic to hit financial markets recently is misplaced. The 'next recession' apparently heralded by the downward stock markets spirals of the past few weeks is false. The truth is that the recession that began in 2007 has not stopped, it's just entering another phase.

To be sure, on economists' technical reading of the data, global growth returned after 2007 – only just. But ask the almost 10 per cent of the US workforce who remained unemployed if the recession stopped. Ask the people of Greece, Ireland, Iceland, Spain, Portugal, the UK and Italy if there's no recession.

What's been witnessed since 2007 is not a recovery from recession in the US and Europe, but a masking of it.

What has to be recognised is that the current application of Keynes' notion that government-induced stimulus is advisable during economic downturns, has failed. That's not to say that Keynes' theory was necessarily wrong. Governments injecting cash into an economy when it has surplus cash may help. Look at China – its post-2007 stimulus seemed to kick its economy along.

But it's totally different when governments stimulate on the back of debt. Look at the US and Europe. Their debt-fed stimuli have not fixed anything. Instead the real problems have been kicked down the road to another time. That other time may have arrived.

The stimuli did do one thing, however. They saved the 'big end of town' from losing their shirts. This was possible because they'd developed the political connections across all political spectrums. Governments in the US and Europe bailed out their banks and big businesses, taking the debts onto government books. This was probably necessary to avert a sudden and dramatic crash. But it didn't fix anything.

What the saving of debt-loaded big business did, combined with government debt stimulus, was to make the big financial traders happy. The government cash only marginally hit the real economy on the ground, but mostly sloshed into the pockets of share market gamblers. This artificially boosted stock markets after 2007, giving commentators reason to say a recovery was under way.

Look what's now happened, however. The big end of town lost its political dominance in the US with the rise of the Tea Party movement. 'Smallville USA' asserted itself. The Republican takeover of the House of Representatives has resulted in the first steps towards the reigning in of US government debt. But it's only a start. Financial game players now realise that a further US debt-fed stimulus is probably unlikely.

In Europe the ability of the European Central Bank and other EU institutions to manage its member countries' debt is at its limit and suspect. There's no more money and no ability to create more government debt. Further artificial debt stimulus is highly unlikely, probably impossible.

Now the financial markets are in a panic. 'There's no one to save us!', they cry. The reality predicted by pessimists is now crunching in. I summarised the worst of the pessimists back in January 2010. Their predictions for the US and Europe appear to be unfolding.

What's developing in the US and Europe is the Japanese scenario. The demographic time-bomb created by the post-war baby boomers is now having an impact. A declining economy is structurally pre-determined. I wrote about this in Business Spectator in June 2009.

The massive ageing of the US and Europe means that lower consumption is locked in for the next decade and beyond. More government debt will not raise consumption, it will squeeze it. There's a huge adjustment under way to the very fundamental functioning of the US and European economies. Stock markets might just now be realising this, albeit late in the process.

What can be observed about stock markets is that over the last period they have been terrible predictors of economic reality. Particularly because government debt fed the stock market speculators' gamble, stock markets have proven unreliable economic barometers.

So don't panic too much about the stock markets' current slide. The bad news has been around for some time. What's important is to focus on the real economy.

Ken Phillips is executive director of Independent Contractors Australia and author of Independence and the Death of Employment.