Stephen King: Corporate ships are still sinking: let's man the fiscal lifeboats

If the consumer engines for a recovery have blown a gasket, are rate cuts likely to be of much benefit?

Last week's Halloween proved suitably ghoulish for the world economy. The recovery that seemed to be falling into place earlier in the year now appears to be stalling, if not going into complete reverse.

Even before last week, we knew that capital spending was facing renewed difficulties on the back of weak US durable goods orders for September. Over the last few days, however, it really has been a case of tricks at the expense of treats. In the United States, manufacturing surveys are suggesting that companies are starting to fret again, unsure about their profitability and unwilling to invest (see left-hand chart). For Europe, the various purchasing managers' surveys were not quite so bad as feared but still suggest that manufacturers are having a tough time. The US saw further – albeit modest – job losses. Not a disaster, admittedly, but certainly not consistent with a decent economic recovery. The mother of all nasty releases, however, was the drop in US consumer confidence (see right-hand chart).

October's fall in consumer confidence may, of course, not be terribly relevant over the medium term. The series does tend to fluctuate from one month to the next in a fairly volatile fashion. And it may have been the case that, during October, the sniper attacks made consumers unusually nervous. Somehow, however, these excuses seem a little bit lame. The decline in confidence was one of the biggest on record. The level of confidence is now lower than was the case post-11 September. And the details of the release reveal that consumers are becoming more nervous about their own incomes – in other words, they're worried about the threat of pay cuts or, even worse, job losses.

Should we be concerned? The answer, most definitely, is "yes". The fall in consumer confidence comes almost two years after the first in a series of aggressive rate cuts from the Federal Reserve Board. The level of consumer confidence is now consistent with consumer spending growth – adjusted for inflation – of no more than 1 or 2 per cent per year. With that kind of growth rate, the US consumer will no longer be in a position to bail out the broader economy. Put another way, the central bank gamble designed to keep consumer spending going until corporate activity picked up is in danger of failing. Companies are in trouble. And consumers are in danger of following suit.

This was not supposed to happen. That it is suggests that monetary policy is not working very well. Think for a second about what central banks had hoped to achieve. They had quite rightly recognised that companies were in trouble. They had decided to offset this corporate problem by persuading consumers to take on more debt. They did this by cutting interest rates. In response, household debt levels raced upwards to the point at which, in the US, interest payments on these outstanding debts – expressed as a share of household income – reached an all-time high, notwithstanding the very low cost of borrowing.

There comes a point, however, when enough is enough. Although economists are hopeless at spotting when that point is reached, it is nevertheless the case that consumers cannot keep building up their debt levels from one year to the next unless they feel secure about two things. The first is simply that interest rates should not go back up again which, for the time being, looks like a very good bet indeed. The second, which may now be proving a lot more problematic, is that consumers have to feel sure that their future incomes will grow at a rate that is consistent with the repayment of the capital associated with any debt. Central banks have delivered the first but may be beginning to have problems with the second. Whether you look at the weakness of US car sales over the last few weeks or the wobbles beginning to come through at the top end of the London housing market, it's beginning to look as though interest-rate cuts alone may no longer be enough to keep consumers spending.

To explain what's going wrong, it's worth going back to the second half of the 1990s. Back then, when companies were investing like crazy on the back of highly optimistic assumptions about future profitability, the seeds of the current mess were sown. Companies accumulated too much capital. The excess capacity – together with greater global competition – drove profits down to levels that left companies both with excessive levels of debt and with pension funds that began to show rather too many holes below the waterline.

The Fed and the Bank of England sent a flotilla of consumer lifeboats out to save this sinking corporate ship. Slowly, slowly, the lifeboats began to drag the crippled ship back to shore. But the closer they got, the more difficult the task; quite simply, the corporate ship took on more and more water, making the challenge for the consumer flotilla ever more difficult.

The central banks gave consumers more fuel and the consumers' debt engines worked even harder. But, at the end of the day, they may simply not have been powerful enough. Have we now reached the point where the consumer flotilla is now being pulled underwater by the very ship that consumers were supposed to save?

It's reasonable to say that the central banks have, themselves, not yet given up all hope. There's now a very good chance that the Fed will cut interest rates again this week, maybe by as much as 0.5 per cent, taking the key Fed funds rate down to just 1.25 per cent. Whether others will follow suit is a rather tricky call. For the European Central Bank, political pressure calling for a rate cut might, for the time being, be met by a stony silence. And, as for the Bank of England, we know there are three members of the Monetary Policy Committee who are keen on lower rates but, as for the rest, there are doubtless still a few worries about the strength of the housing market. Whatever the outcome, it certainly is a very close call.

But if the consumer engines have blown a gasket, are rate cuts likely to be of much benefit? After all, we have had loads of rate reductions in the US already yet here we are still worrying about whether the cuts seen so far are really doing the trick. The point is this: companies are still in trouble and shareholders and bondholders are demanding that something should be done. For companies, there are limited options: they can cut back on capital spending again or alternatively they can cut back on labour costs. The implication appears to be that companies will be trying harder and harder to pass the burden of adjustment on to their workers and, more generally, on to consumers.

I've argued before that, under these circumstances, it might be better to think about alternative ways of patching up the sinking corporate ship. If companies have too much debt or not enough profit, it may be time for some more radical repairs. At the beginning of the 1990s, there were plenty of leaky corporate ships. In the US, the problem was solved by using taxpayers' money to bail out the savings and loans companies. In Sweden, taxpayers' money was used to nationalise the banks, thereby reducing the risk of persistent financial distress. In Japan, nothing was done: the consequences are now all too obvious. Perhaps now is the time to man the bailout lifeboat again, targeting fiscal funds towards an orderly rescue of corporate balance sheets.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com