The dots in the title of this week’s contribution stand for the word “stupid”. In fact the title is borrowed from the now (in)famous saying “It’s the economy, stupid”, which in itself is a slight variation of the phrase “the economy, stupid” used in the US presidential campaign that had got Bill Clinton elected. Let me start where I left off last week.

Last week I claimed that that the Chinese economy is not in trouble, as what was taking place then and is still in process this week, is part of a process of readjustment. Fundamentals of the Chinese economy are still positive, notably employment and investment. So one gets to the conclusion that the turmoil and volatility that we have experienced in the last few weeks, and especially in the last eight days have more to do with financial markets than the productive economy.

Hence the title; It’s the markets, stupid.

It is interesting to note what the governor of the Bank of India had to say yesterday. He feels that governments are expecting too much of central banks when it comes to fixing the world’s economic problems.

What counts is not how the financial markets behave but the way the economic fundamentals develop

In an economic recession, central banks can provide a temporary boost to the economy by making money cheaper and more plentiful as this would encourage spending and investment. In fact this is the whole objective of quantitative easing, a policy adopted by the Federal Reserve and the Bank of England in the past years and by the European Central Bank at present.

However, if the weaknesses in an economy have to do with inefficiencies, lack of competiveness, loss of productivity, then no amount of quantitative easing will fix that economy. Governments together with the business sector would need to address such issues. This is why the economic fundamentals such as investment, employment, demand, exports, inflation, are more important than the financial markets.

At a presentation I attended this week, the speaker alluded to the financial markets anticipating what may be happening. And he was right. Today financial markets are no longer reacting to economic data of countries or companies, but are trying to anticipate what the data will be, thinking that they have a gift which no one really has – knowing the future.

This is why we should make a very clear distinction between what happens in the financial markets and what happens in the real economy. Unfortunately the short term view taken by businesses and investors, where reporting a fall in the share price is seen as a cataclysmic event prevents us all from analysing the fundamental data.

It looked very confusing when earlier this week, most stock exchanges our side of the world recovered from the losses they sustained at the end of last week, even though there was no recovery on the Shanghai Stock Exchange. Why did this happen, if it not a clear example of short termism by markets?

Admittedly, John Keynes had said that in the long run we are all dead. However he was certainly not advocating that we take notice of the volatility in the financial markets. What Keynes had advocated was that we cannot wait for the market to sort out its own problems, as it may be too late by then. So some form of government intervention is necessary to set things on the right course; and rightly so.

Let me get back to China. We need to keep in mind that this country is a significant lender to the governments of most of the major economies. This level of lending is certainly not a sign of economic trouble. The economy needs to go through a period of re-adjustment for various reasons.

However, what counts is not how the financial markets behave but the way the economic fundamentals develop.