Hamish McRae: No one can say if this is a pause in the recovery – or another leg of recession

Economic View

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The Independent Online

You could see it as a bomb under their backsides.

The shocks running through the financial markets over the past few days have shown the global leaders gathering in Washington for the annual meetings of the International Monetary Fund and World Bank what investors think of them. The big tumble in share prices, creating what is technically a bear market – a fall of more than 20 per cent from the peak earlier this year – in most major countries is a vote of no confidence. Investors don't agree on much but they do agree that the policy response by both Europe and the US has been lamentable.

Europe is in the dock for mismanaging its bail-out of Greece, while the US is there for mismanaging its bail-out of the American economy. Meanwhile, the leaders of the emerging world look on with growing contempt at the ability of the developed world to manage its financial affairs. Remember, what we have gone through is seen in much of the world not as a global recession but a North Atlantic one. There was no recession in the emerging world, taken as a whole.

That should be the starting point for judging whether this pause in the recovery that most developed economies seem to be experiencing is just that, a pause, or something more ominous: another leg to the North Atlantic recession. To oversimplify, the mainstream view is that it is, probably, a pause; the view of the markets, insofar as one can deduce from the falls in share values, is that it is quite likely to be another recession. So which is right? In truth, no one can know, but let's look at the evidence.

Well, the first thing to be clear about is that everyone accepts that the sky appears darker than a few months ago. The reality may not have changed, or not much, but the perception has. The graphs, taken from the IMF's new World Economic Outlook, show its economists' best judgement as to what might happen. The main one demonstrates how the emerging world escaped recession and continues to grow strongly, but also how the developed world, while still likely to continue slow growth, lags far behind.

The smaller one looks at the possibility of another recession in four large economies, including our own. The risks for the US in particular do look uncomfortably high.

It is harder to calculate a "probability of recession" chart from share-price movements. Sudden price falls have often signalled major downturns in the world economy, typically with a lead of three to six months, just as recoveries have signalled a return to growth. They did catch both the last downturn and the subsequent upturn. But they have equally often cried wolf. Insofar as they are saying anything coherent now, they seem to be signalling that there will be a mild recession, at least in the US, not as serious as the previous collapse but not nice either.

So what can be done, or, more pertinently, what will be done? I don't think we can expect much from Europe. It is not just a question as to whether Germany will sign the cheques for Greece, though that is a tough one. Nor is it just a question of how Greece will default, though that is inevitable. The fundamental problem of a fixed exchange-rate regime remains.

You have to have some way of making adjustments between countries if they retain control over their own finances. Otherwise you have to go to a full fiscal union. In Europe that would mean, in practice, Germany, as de facto guarantor of eurozone debt, being able to override the decisions of other countries' parliaments. That is not going to happen, and in the absence of that, expect more muddle-through.

Is muddle-through a catastrophe? The legitimate reason for trying "to kick the can down the road" is that the longer people have to prepare, the more that can adjust for the inevitable. So it would be better for Greece to default formally next year or the year after than it would be for it to do so in a disorganised way now. But postponement creates uncertainty, and this is a bad point in the economic cycle to do that.

In the US, we have just seen this past week the limits of the power of the Federal Reserve to boost the economy. It tried to drop long-term interest rates by swapping long and short-term securities. The impact, at least on confidence, has been wholly negative. The US authorities may not be completely out of options, but the cupboard looks pretty bare.

And yet. The other half of the world is racing on. Growth in China may be coming down a little but that is welcome because of fears of overheating and associated inflation. India is racing on. The worries there are about distribution of the wealth – how do you push it downwards – rather than growth as such.

And this is not just about the Brics; Brazil, Russia, India and China. There are other large growth economies, such as Indonesia or Turkey, where growth continues. The emergence of the Group of 20, rather than the Group of Seven, reflects this shift in economic power. Go back to that main graph. The world economy as a whole is growing and will continue to do so; it is our bit that is in trouble.

That leads to a further thought. There is the debate as to the nature of this slowdown. My view remains that a pause is more likely than a second leg to the recession, at least in the UK. But we will see. There is however another debate that seems to me to be even more important. Put crudely, it is: what are we in the developed world doing wrong and what are they in the emerging world doing right?

It is almost shaming to have to admit that countries that we might regard as less sophisticated in their economic management and commercial structure are achieving high growth while we are fretting about decline. This is very obvious at a macro-economic level, but it is also evident at a micro level. Look at the way Tata has turned round Jaguar Land Rover, where Ford, and of course our own national managements, had failed – a new plant was announced just a few days ago.

It is too big a topic to tackle here, but when the dust settles from this current kerfuffle surely one of the lessons is to figure out how the other half of the world seems to be coping so much better than we are.

It may not help globally, but there is a silver lining to the clouds over the UK

Viewed globally, what happens in the UK may not be that important but it matters to us. This is party conference time and there is a lot of noise about that, but I don't think it is a political matter. We are where we are.

Three things stand out. First, growth is worse than predicted a year ago, not just by mainstream private sector forecasters but also by the Office for Budgetary Responsibility and the Bank of England. And that holds true even if the official figures understate what has actually been happening.

Second, inflation has been very much higher than forecast.

And third, while the progress this year towards narrowing the budget deficit may have slipped a little, it is not far off the target set out last year. Put these together and what do you get?

Well, it is disappointing but there may be a silver lining to these clouds. If we had been more successful at controlling inflation but had experienced the same growth in money GDP, real growth would have been higher. Money GDP has grown pretty much as expected. The problem has been that too much of that has shown up in higher prices rather than a rise in real output. You can see this at consumer level – had fuel prices been lower we would have had more money to buy stuff. This higher-than-expected inflation has also helped keep revenues up, despite the slower growth.

Looking ahead, it seems reasonable to expect it to come down next year quite swiftly. As that happens, the reverse effect on real incomes will occur: the rise in money GDP will nudge back towards real growth rather than be absorbed in price rises.

And progress on cutting the deficit? Well, the Chancellor has cut himself a little slack. He can, if things really slow down, correct the deficit over five years instead of four. It is still Plan A, but done a bit more slowly.