Hamish McRae: Britain may be too close for comfort to the US when a recession strikes

Our banks' exposure to the US is equivalent to 8 per cent of the UK's GDP
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The Independent Online

The issue is still really America, so you have to start there. The miserable week on the European stock markets really reflects what is happening on US markets, for though the European and US economies look to be increasingly out of synch, our markets still dance to a transatlantic tune.

The issue is still really America, so you have to start there. The miserable week on the European stock markets really reflects what is happening on US markets, for though the European and US economies look to be increasingly out of synch, our markets still dance to a transatlantic tune.

But of course there is a feedback effect. The longer US market disarray continues the greater the risks of a US recession. While the European economy could probably ride through a brief recession, anything serious would undoubtedly undermine the European economy - and hence justify the present misery.

So what do we know? The risk of recession is now estimated by the professionals to be something between one-third and one-half: for example Deutsche Bank puts it at 40 per cent. It looks as though the US economy will have contracted in the first three months of this year and so whether there is a technical recession will turn on the April/June quarter. There has been a sharp fall in both business and consumer confidence (see graph) and while these have not fallen back to the levels of the early 1980s or the early 1990s recessions, the rate of decline is startlingly sharp.

To be clear, though: the majority view remains that the US will escape recession and even those that incline towards the minority view believe that if there is a recession, it will be brief. My colleague Diane Coyle argued here yesterday that the greater responsiveness to swings in demand should enable the US to correct quickly. In theory at least a just-in-time economy ought to experience smaller swings in output than one that allows large stocks to build up, which then have to be unloaded on a weak market.

The US may indeed be a just-in-time economy; nevertheless there are two reasons to believe that the present global cycle will broadly resemble previous ones. The first is that the rest of the world is not so nimble as the US; the second that even if economies are becoming be more stable, financial markets are not.

Anyone trying to compare the responsiveness of the US economy to those of the UK, Europe or Japan has to rely on intuition rather than data. I have not seen any thorough comparative studies - the changes in the US are so new that similar work has yet to be done elsewhere. But if you look at the way in which companies in the rest of the world respond, there is surely a greater cultural reluctance to shed labour, which in any case takes longer even if the will to do so is there. Nor have other countries seen the surge in IT investment that has occurred in the US and IT has become the backbone of the just-in-time way of running a company.

In practical terms, this is an issue for Europe, rather than Japan. Japan is not going to be a significant contributor to world demand this year and it may become more of a drag on the world economy. For Europe (and the UK) we should therefore assume that there will be something of a flywheel effect: even if final demand starts to come off it will take several months before this feeds through the whole economy. Result: the UK and Europe will have a better year for growth than the US, but their growth will be loaded towards the back half of the year, whereas ours may turn out to be skewed towards the front half. Of course the danger is that the US will have a second leg to its downturn at the same time as Europe is experiencing its first.

The danger of that is increased if markets have in general become more volatile. The US hi-tech boom of last year, and its subsequent bust, now looks like one of those once-in-a-generation speculative excesses. The "it really is different this time" view has been shown to be plain wrong. But that is different from the charge that financial markets have become inherently unstable. They always have been unstable.

The charge is rather that financial market instability matters more than it used to for three main reasons. First, more of the population, particularly in the US, has money directly in the markets and so market movements affect spending more than they used to. Second, companies have come to rely more on market (as opposed to bank) finance and so are more vulnerable to its moods. And three, globalisation has the effect of increasing contagion so that market movements in one country affect companies (and maybe even consumers) in another to a much greater extent than they did a generation ago.

There is a practical question here for the UK as to "the impact of the US slowdown on the UK economy". That quote is the title of a speech yesterday by Sushil Wadhwani, member of the Bank of England Monetary Policy Committee and prior to that, one of the most thoughtful commentators on the interaction between financial markets and the real economy at Goldman Sachs.

Dr Wadhwani's view is that there are indeed very close links between the US and UK economies - did you know that our banks' exposure to the US is equivalent to 8 per cent of UK GDP? But there are also many uncertainties, so qualifying the spill-over effects is pretty difficult. Models that just look at our exports to the US don't take into account third country effects: for example, the fall in demand from East Asia, a region heavily dependent on exports to the US. Historically, our economic cycles have certainly been closely correlated with the US ones, more closely than those of continental Europe. But that is not the same as cause, so the relationship may not remain.

His practical advice to business leaders is that they must be careful when entering into medium-term commitments because there are considerable downside risks in the world economy. That must be sensible. But of course the effect - were they to do so - would be for the caution of the US business community to spread here very speedily. The argument comes full circle. What happens in the US matters enormously to the rest of the developed world - and it matters particularly to Britain. The closeness of the special relationship in political terms may be often overstated, but there is special (if one way) relationship between our economies. The issue is what happens in America.

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