Bill Robinson: Recession? Yes, I suppose so. But not like the old days

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The Independent Online

Ten days ago the Bank of England cut interest rates. Last week it published the Inflation Report which explains why. "Unfortunately, we sprang a surprise," said the deputy governor, Mervyn King. You might think a cut in interest rates was good news. But the markets have taken this unexpected cut as a sign that things are worse than they thought. That is why the surprise was unfortunate, and the papers are full of recession talk again.

It is important to keep a sense of perspective. Although the manufacturing sector is now officially in recession, with output falling, it is a small part of the economy. The Inflation Report, shows total output has merely slowed, from 3 to 2 per cent. The Bank expects growth to continue at that rate for the next couple of years. That is below trend, but it is nothing like the major recessions we experienced in 1990 or 1980.

Recessions are often caused by some earlier excess. The 1990 recession was the product of the housing boom of the late Eighties, when households became over-confident and went on a spending spree. They were then subjected to the high interest rates of the early Nineties, in place to defend sterling's membership of the ERM. Debt service costs soared relative to income, to the point where some homeowners became forced sellers. The resulting drop in house prices damaged personal wealth. As households tried to reduce their indebtedness, the savings ratio soared and a recession ensued.

The earlier excess underlying the present slowdown is the internet-linked boom in telecoms, media and technology (TMT) stocks. In the TMT boom, financial discipline was weak because new equity finance was so easy to come by. Many projects of dubious economic value were put in place. This became apparent only when profits started to disappoint expectations, leading to a sharp correction in equity prices. Some companies, in the middle of an investment programme and starved of new equity capital, went to the debt markets. Others cut investment.

The present downturn is thus being led by businesses that are worried and short of confidence. It has been a profit-led recession, now feeding through into the real economy via a fall in investment. So far, households have been unaffected. The loss of wealth due to the stock market correction is nothing compared to the damage inflicted by the housing slump in 1990. Consumer confidence remains high, not least because employment as a percentage of the working population is as high as in the late 1980s, and real wages continue to grow.

Will that change? Certainly there is a downside risk, because the personal savings ratio remains close to an all-time low. But the Bank has done an interesting analysis which shows that the savings ratio rose in the last recession only when households' interest payments rose relative to disposable income, and their borrowing started to rise relative to their wealth. Both events were caused, last time around, by the sharp rise in interest rates. That is not on the cards at present.

On the other hand, the financial position of companies, is less comfortable. The fall in profits means that the debt levels are higher, relative to company incomes. And the correction in share prices means that the debt owed by companies has risen relative to their market value. The consequence is that the most indebted companies now have balance sheets which are significantly more stretched than in 1980 or in 1990.

Will these companies try to boost profits by laying off labour, damaging consumer confidence and triggering the rise in the household savings ratio that drove the 1990 recession? Or will they reckon that current levels of debt are sustainable because interest payments are lower, and growth prospects so much better than in the early 1990s?

You can see the next six months as a kind of race. If business confidence recovers before consumer confidence falters, the slowdown will be as mild as the Bank predicts. But if the deterioration in conditions continues, triggering actions by business that damage consumer confidence, we could yet see this mild downturn transformed into a recession that would register on the Richter scale.

I share the Bank's optimism that the nightmare scenario will be avoided. But you have been warned.