Stephen King: Central bankers blow bubbles in bid to balance rates and recovery

'The world has been through the most severe financial crisis since the Great Depression. The crisis in turn sparked a deep global recession, from which we are only now beginning to emerge."

The concluding remarks of Ben Bernanke's comments last week to the Jackson Hole Central Bank Symposium, where late in the evening the punchbowl sometimes isn't taken away fast enough, sound dismal but, at the same time, they offer a glimmer of hope. We may have been in recession but there's a reasonable chance we're now beginning to pull our way out, in part because the "panic" of 2008, as Bernanke describes it, has been brought to an end, helped by a judicious injection of liquidity from the world's central banks.

As recessionary forces abate, and as activity begins to pick up again, the next stage of the debate will focus on when the very accommodating monetary stance of the world's central banks will begin to be reversed. The expansion of quantitative easing announced by the Bank of England the other week suggests that, in the UK, there is no sense of urgency to withdraw monetary support.

The Federal Reserve isn't being quite so free and easy with the printing press at the moment but it's also in no hurry to start taking away excess liquidity.

Although there have been some encouraging signs of economic stabilisation in parts of continental Europe, Jean-Claude Trichet is in no mood to talk up recovery prospects. At Jackson Hole, he warned of the dangers of complacency: "... because we have some green shoots here and there, we are already saying: 'Well, after all, we are close to back to normal'. We know that we have an enormous amount of work to do and we should be as active as possible."

There are, in fact, some good historical reasons for central bankers on the eastern side of the Atlantic to be more cautious than those on its western side. US recessions tend to be V-shaped: a quick collapse followed by a sharp rebound. UK and German recessions, in contrast, tend to be U-shaped: an equally quick collapse but then a number of quarters in which their respective economies seem to spend their time wallowing in the recessionary mud.

One explanation might be that the US is simply more flexible. That flexibility can be seen in two distinct ways. First, there is more of a hire-and-fire mentality, allowing companies through both booms and busts to cut their workforce cloth to fit. Second, the US has a well-established consumer credit market. Those workers who fall temporarily on hard times are able to carry on spending via additional borrowing, thereby preventing the economy from stagnating in European style.

Every recession, however, is different, in terms of both initial causes and subsequent progression. The US labour market still looks flexible today, but the US credit market is a lot less accommodating than before. Many homeowners who, routinely, would be able to get access to easy credit no matter what their personal economic circumstances were will now struggle to find a friendly bank manager. Banks are either unwilling or unable to extend the volume of loans that had been on offer before the credit crunch began to bite.

Let's imagine, however, that the US has retained its much-vaunted flexibility. If so, the UK begins to look increasingly puzzling. Post-Margaret Thatcher, the UK economy was also supposed to have developed the "flexible" Anglo-Saxon attributes of the US yet its recessions still tend to be longer and deeper than America's.

Is this a different kind of flexibility, or is flexibility not all it's cracked up to be?

Part of the issue is simply size. The US and UK economies are not directly comparable. It's much more sensible to compare the US with, say, the European Union as a whole. Like the US, the European Union in aggregate tends to have relatively short recessions. Within the European Union, however, individual countries can still have prolonged recessions. So long as these national recessions don't happen contemporaneously, some countries will be coming out while others may still be going in. For the Union as a whole, the recession will appear to be quite short. The same logic applies to the US: California may have a particularly long recession, say, but that may have no direct relevance for economic developments in South Dakota.

Size, however, is not the only issue. Throughout the post-war period, US recessions have never involved the housing market in a major way – at least, not until now.

UK recessions, in contrast, have been influenced by the housing market with alarming regularity: in the mid-1970s, the late 1990s and, of course, today. Falling house prices eat away both at credit availability and at the willingness of consumers to borrow.

If a country has depended on continuous increases in house prices to sustain debt-fuelled consumer spending, a fall in house prices can have devastating results.

The US consumer certainly isn't dead and buried but, as house prices have dropped, the saving ratio has drifted up over the last couple of years, a marked contrast with the "spend, spend, spend" behaviour which had typified the US consumer. This either reflects higher savings or, more likely in many cases, reduced borrowings (including the repayment of existing debts). US consumers are living through a period of austerity rather more familiar to many generations of their British brethren.

So while history suggests the US will come out of this downswing sooner and more aggressively than countries in Europe, many puzzles remain. Moreover, as the world's foremost expert on the Great Depression, Ben Bernanke knows that, even with signs of recovery, there is no reason to rush into a premature tightening of monetary policy. People too often forget that the 1930s included two depressions: the Great Depression which reached its depths in 1932 and another depression which hit in 1938, long after Roosevelt's New Deal. Arguably, this "minor" depression was a response to premature monetary tightening by the Federal Reserve which, at the time, was still very much learning the monetary ropes.

The Federal Reserve also worries about Japan's experience in the 1990s. The more I look at Japan, the less I'm convinced that its lost decades can easily be explained through monetary mistakes made by its central bank. Population ageing and outsourcing of industry to China played, I suspect, much bigger roles. Nevertheless, there are plenty of people at the Federal Reserve who believe the Bank of Japan raised interest rates too hastily on a number of occasions over the last 20 years, in effect scuppering any chances of recovery.

The good news from all this is that interest rates are likely to remain low for a long time as central banks try to guide the world economy out of the quicksand of the credit crunch and the failure of the world's banking system. In the process, asset values may continue to recover from their earlier lows. The bad news is that the continuation of low interest rates threatens to encourage a return to the excessive risk taking seen over the last 20 years. Central banks, it seems, are forever blowing bubbles.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com