It is unlikely that the new elite of central bankers, advised by econometricians, has learned how to avoid financial bubbles

The pendulum of fashionable financial opinion has swung from predictions of doom around the time of the emerging market crisis little more than a year ago to one of euphoria. On the whole, political leaders have been more restrained than financial market enthusiasts. But even Lawrence Summers, the US Treasury secretary, has delivered an upbeat message in a keynote speech.

He was not only optimistic about the US, which will soon announce the longest ever period of sustained economic expansion. He was also, by his standards, relatively optimistic about other developed countries after years of criticising them for not doing enough to sustain growth. He envisaged a soundly based upturn in Europe and at least some improvement in Japan, even if that did not go far enough. It is just when such optimism is in the air that one should keep a weather eye for trouble.

The threat is the familiar one of an overvalued US stock exchange, which finds a less extreme echo in the other bourses of the world. But there are two subtleties that have escaped attention.

First, the financial bubble is not simply a sideshow in a booming US real economy. It is an essential part of that boom. The private sector is running an unprecedented financial deficit which can only be maintained because the soaring value of financial assets - and to a lesser extent real estate - provide the impression of ever increasing wealth. Should that change the proverbial hard landing would not be far away.

Second, with most economic threats, it is possible to say whether the problem is one of inflation or recession. But when the threat comes from financial markets it is twofold; first an unsustainable inflationary boom, which is then followed by a bust.

Financial bubbles have been a feature of capitalism from the beginning and it is unlikely that the new elite of central bankers, advised by econometricians, has learned how to eliminate them. The interesting question is how stretched the bubble is and what the effects are likely to be when it bursts.

An analyst at Phillips & Drew, Alistair McGiven, has made an attempt to quantify the degree of Wall Street overvaluation. By traditional measures this is extreme. The dividend yield on the S&P 500 is much lower than it has been on the at any time since 1910. So is the earnings yield, with the exception of the depression year 1932 when presumably earnings collapsed even faster than equity prices.

The novel feature is his attempt to adjust for forces in the new economy "that may plausibly influence fair values and so justify current market levels". He does so by adjusting these yields for more optimistic market expectations about inflation, a lower equity risk premium and faster trend output growth. He maintains that adjusted measures have been able to predict the market except for the last fabulous couple of years. On the basis of these adjusted earnings and dividend yields he estimates that the US stock market is still about 50 per cent above fair value.

What, however, I do find fascinating is that Neil Williams, the global strategist of Goldman Sachs, which has hitherto taken a more optimistic view, is now beginning to issue warning noises. His analysis suggests that, outside information technology, the global equity market looks expensive relative to historical levels, "but probably not excessively so" - in statistical terms about one standard deviation "richer" than the recent average.

Turning to IT valuations, he admits that these look very expensive on any standard measure, but estimates that future earnings growth implied by current valuations are "not far out of line on what technology has achieved in the last five to 10 years."

Maybe. But when he adds up the earnings growth rate necessary for both the IT and non-IT sectors to offer "a decent equity risk premium", he finds that the "required growth rate in market earnings comfortably exceeds the likely growth rate of the wider economy". Although he remains "neutrally weighted" towards stocks he adds they are nevertheless "vulnerable to unpleasant surprises on either the earnings or the interest rate fronts." Or as I would summarise it, the risks are on the downside.

Coming to aspects where I feel more at home, the Goldman Sachs central simulation suggests that the profit share in global GDP could rise to 19 per cent within 10 years - a level unprecedented for a quarter of a century. But supposing we look back still further, what do we find? For the US alone, the share of profits in GDP was higher for a period in the mid 1960s than it is today. But both the world and the US economies are far more competitive and there are more pressures on profit margins that there were 30 or 40 years ago. So it is difficult to see a sustainable increase to anything like these levels. Indeed the share of domestic non-financial profits has been gradually declining in the last couple of years.

The UK is particularly vulnerable to any shake-out in world financial markets. This is due not only to the overall impact of Wall Street on world economic activity. A specific factor arises from the structure of the UK's external balance sheet which has led the London financial firm of Smithers & Co to issue a paper Britain: the World's Largest Hedge Fund?

The point is that the British corporate and personal sectors have borrowed short and lent long. They have also borrowed in fairly stable markets and reinvested in risky investments. The result is that although on a conventional balance sheet valuation, UK overseas liabilities exceed UK overseas assets, nevertheless, the UK has a large substantial net positive overseas income.

The effect of all these financial activities is to reduce the UK balance of payments deficit from nearly 5 per cent of GDP to less than 2 per cent. Should the returns from financial activities begin to dwindle, the UK current deficit could reach a level where it worries holders of sterling.

Although the Bank of England has no explicit sterling target, fears that the pound might go even higher have restrained it from raising interest rates more than it has done. If instead the pound were to fall drastically, any relief that this might bring to UK manufacturers would be offset by Bank action to raise interest rates even more than is in any case likely.

So my guess is that market estimates of a peak in UK base rates of 7 1/2 per cent may be nearer the mark than the more modest expectations of many economists. This pessimism about base rates will be falsified if a Wall Street shake-out comes first and central banks move back towards cheaper money. But that would hardly be a relief to those who worry about the interest rate prospect. Either way, any hope of big increases in funding for the NHS and other public services without an increase in the tax burden is for the birds.