Stephen King: Weight of debt threatens to crack the foundations of our economic edifice

Typically, experiments are carried out to find out what will happen under "controlled" conditions. The natural sciences obviously rely heavily on experiments. Form a hypothesis, test under experimental conditions and, hey presto, you might be lucky enough to come up with a halfway decent theory.

Typically, experiments are carried out to find out what will happen under "controlled" conditions. The natural sciences obviously rely heavily on experiments. Form a hypothesis, test under experimental conditions and, hey presto, you might be lucky enough to come up with a halfway decent theory.

Of course, it's not always easy to carry out experiments. Einstein's Theory of Relativity was full of clever things, but he wasn't able to carry out the experiments that might have proved - or falsified - his ideas. Fortunately, though, his theories were designed so that they might eventually be verified, perhaps through astronomical observation or by putting atomic clocks in planes and flying them around the world.

When it comes to economics, it's a bit more difficult to subject theories to rigorous testing. When does any policymaker have the luxury of being able to "control" his environment? And even if a mad professor came along who was able to exercise some degree of control, how could he be sure that the results would repeat themselves time after time? After all, we learn from our mistakes - and, for that matter, sometimes forget the mistakes of earlier generations - so the chances of constant repetition, in the form of a natural law, seem pretty remote.

Nevertheless, in economics, experiments do happen. We may not always realise they're happening, but there's no doubt that policymakers do, from time to time, take risks, the economic equivalent to scientific experiments. They may not be sure of the outcome, but they think they have a good idea of what might eventually happen, sometimes because they are, as Keynes would have said, "slaves of some defunct economist". If their expectations are dashed, however, there's a good chance the theory they were previously using will be junked. Which is another way of saying that, in economics, experiments happen, even though the financial costs can sometimes, unwittingly, be a little too high.

It seems to me that we're in one of those experimental phases today. Many people look at the current state of the world economy, shrug and wonder what's changed. From a cyclical point of view, we had a recession and now we've got a recovery. Isn't that the normal pattern of business cycles? And, if it is, does this not provide evidence, if any more was needed, that there is a natural law in economics, a waxing and waning of economic conditions that we all have to live with?

Unfortunately, this kind of evidence is no more than circumstantial. Business cycles may appear to be similar, but their underlying causes often differ. This time around, the unique feature of both recession and subsequent recovery must be the behaviour of balance sheets: gains and losses in asset prices and their subsequent impact on people's attitudes towards debt.

Back in 2000, when the equity bubble burst, companies found themselves in a bit of trouble. The falls in equity prices were a signal that earlier expectations of profits growth were heavily inflated. In response, companies began to believe they'd borrowed too much and chose to repay their debts. By doing so, the corporate sector's marginal propensity to invest declined, implying a rise in corporate saving.

As any good Keynesian will tell you, a rise in corporate saving, other things equal, will create a downward multiplier effect, leaving the economy potentially in a parlous state. With inflation already very low, central banks started to panic: if companies were saving more and no one else was saving any less, was there not a significant risk of deflation? And, if so, was there not a danger that the US economy, and other economies, could head into a Japanese-style abyss?

At this point, policymakers decided that an experiment was required. If the rise in corporate saving was no more than transitory - a one-off adjustment to the excesses of the 1990s - perhaps policymakers could offset its dampening effects through a reduction in saving elsewhere. And so the US and the UK embarked on a major loosening of fiscal policy (in the UK's case, the timing was more accident than design) and cut interest rates to levels that homebuyers and consumers found irresistible.

And so the world was saved. The US recession was both short-lived and shallow while the UK avoided recession altogether. Admittedly, consumers had a lot more debt on their balance sheets than before - as did governments - but this wasn't such a big problem: after all, with house prices now a lot higher than before, higher levels of debt were backed by still higher levels of assets. Seemingly, a miracle had happened: simply by lowering the level of interest rates from their historic norms, consumers had become wealthier and economies were back on track.

When you think about this, the argument doesn't seem terribly credible. If low interest rates can make people wealthier, then why not keep interest rates low all the time? There are two possible retorts to this. First, low interest rates may lead to excessive monetary growth and, hence, higher inflation. Earlier this year, markets began to fear just such an eventuality but that fear seems to be dissipating. Second, low interest rates may distort the timing of expenditures: if rates are low today but likely to be higher tomorrow, I'm more likely to borrow today but save tomorrow. That's good news for sales of plasma TVs in the short-term, but a lot less helpful longer term.

It's this second example that's especially worrying at the moment. The hope, both in the US and the UK, was that companies would eventually get over their collective hangover. After paying off a bit of debt, they would eventually go back to investing again. And, as they did so, consumer spending would then be able to slow down without economies tipping back into recession.

This part of the story, though, is looking a bit shaky. British investment has ground to a halt over the past two quarters. US companies are warning of more difficult times ahead. Managements are choosing to hoard cash rather than invest. Overall, companies are still saving rather than spending.

Meanwhile, households, now with more debt than ever before, are struggling. UK base rates may not seem terribly high at just 4.75 per cent but with housing softening and with consumers retrenching, it increasingly looks as though households are a lot more sensitive to historically low interest rates. US Fed funds probably haven't reached their peak yet but with payrolls having weakened again and with business surveys progressively deteriorating, it's looking less and less likely that Fed funds will ever get to 4 per cent. And if rates peak at such low levels, they also can't come down very far - suggesting that, if economies slow, central banks will only be able to launch monetary dinghies, not genuine lifeboats.

Basically, the monetary and fiscal experiment that started four years ago hasn't, yet, been completed. We know some of the results - consumers can be persuaded to spend when equity markets are falling - but we don't yet have all of the results. We don't know, for example, what will happen when consumers start to re-trench. Recent data, though, look increasingly worrying: there appears to be no convincing corporate renaissance coming through to take the burden off the consumer in the months ahead. Interest rates may be peaking at unusually low levels, but this can only mean that the underlying foundations for this economic recovery are unusually weak: the whole edifice is in danger of subsiding under the weight of excessive - and policy-induced - debt.