Economic View | Hamish McRae

Next year we'll get growing
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The Independent Online

We economists are not very good, are we, at telling people what is going to happen to the economy? Hardly any of us forecast that all three main developed regions, the US, Japan and the eurozone, would be in recession by the end of the year.

It is useful, if humbling, to see what one was writing a year ago and I have just been doing that. Yes, I did pick up "the strong possibility, maybe a probability" that the US would have a recession. And, correctly, I thought Britain would escape recession even if the US did not. But I also thought continental Europe as a whole would be all right, while its performance has been almost as bad as that of the US. And I expected that reforms in Japan (which have not come) would lay the base for recovery.

Actually, this is not at all bad compared with some of the highly paid City forecasters. The only really prescient comment a year ago I have found was the line taken by the HSBC team, which said "why Greenspan's Fed may be unable to prevent a US recession". Among the worst was the work of Gavyn Davies's team at Goldman Sachs. I treasure its forecasts of last January, for they are real clunkers. The first message was "The Fed rescues the US", bringing growth up to 2 to 3 per cent in the second half of the year. The second was "low recession risks elsewhere". Even on its downside scenario, neither the eurozone nor Japan experienced recession.

Why did one house get it right and most of the others get it wrong? As far as the US was concerned, the single biggest reason was that the pessimists did not believe low interest rates would stimulate demand while the optimists did. If your forecast for the US is wrong, the rest unravels; get the US right and the only way you get the rest wrong is to misjudge the power of the links between the States and the rest of the world.

This question – will low interest rates crank up economic growth in 2002? – is arguably the most important economic issue facing the world in the coming year. The rates have failed so far but that could simply be because of time lags. If they fail next year then, well, there aren't many any other policies on offer, I'm afraid, for there are limits to the effectiveness of fiscal policy, as Japan has demonstrated.

OK, let's come clean. I do think there will be some sort of recovery next year and that low interest rates and particularly the easy liquidity will be an important reason. But I have worries about this, of which more later.

The best reason for confidence is that there is such a thing as the business cycle. The top graph shows the curious, seemingly inexorable swings of the economic cycle over the past 40 years. Goes up, goes down, goes up, goes down. The amplitude and the timing of the cycles vary and, as you can see, during the Sixties, output remained above the base line. Individual countries had recession but the developed world taken as a whole did not.

The least successful period was the Seventies when the combination of the first oil shock, the surge in inflation and the high interest rates needed to control this created a synchronised recession. In the early Eighties the world just dipped into recession, while in the early Nineties it just avoided this.

The obvious response to this graph is to say the pattern will be continued and the line will jump up pretty much as Merrill Lynch predicts; the dotted line is its forecast. Since the number crunchers have been so wrong, let's accept that touchy-feely, unscientific judgement. But it is comforting to have an intellectual basis for such an intuitive view. Remember what the former Irish Prime Minister, the econo- mist Garrett Fitzgerald, was reported as saying when confronted with some economic policy: "Yes, I can see how it would work in practice, but I am trying to figure out how it would work in theory."

The theory is in the bottom two graphs. On the left you see that short-term interest rates in real terms (ie after allowing for inflation) have become close to zero: money is free. On the right is a calculation of the implications of not so much the low rates but rather the amount of money being pumped into the system by the central banks. This is loadsamoney time. The conclusion of the Bank Credit Analyst team which did the sums is that the monetary stimulus is greater now than at any time during the past 30 years.

That is pretty amazing. It would be even more amazing if it did not have some effect. There are only two reasons to doubt the impact: one is the experience of Japan; the other, the possibility that very low short-term rates in money terms might be offset by falling prices so real rates do not fall enough, particularly if long-term rates were to rise.

The Japanese experience is certainly a warning to all: back into recession again with no end in sight. The problem, though, is largely structural: its banks have made so many bad investments that they are unable to lend for potentially good ones. Failure to reform the banking system, and myriad other regulations which inhibit domestic demand, are a key part of the problem.

But they are not the whole problem. Look again at the bottom-left chart. Rates are close to zero but they are not negative, as they were in the Seventies. If prices are falling, maybe even free money is not cheap enough. Couple that with the rise in rates now seen on the bond markets and maybe even lots of very cheap money will not stimulate borrowing, and growth.

I happen to think it will, certainly here and, more importantly, in the US. Once the US economic recovery seems secure, probably by next summer, we can relax a bit. But not too much.

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