Stephen King: Staring at a new age of austerity

At this stage, we can't be sure we haven't been looking at a phantom recovery

As I glanced through the weekend press, I detected a growing sense of envy. The UK economy is still struggling to pull its way out of its recession while the US economy, apparently, is back to its bouncing best. Certainly, the numbers from the final quarter of last year seem to support this view. The UK economy expanded at a meagre 0.3 per cent rate, after a small upward revision, but the US economy managed to spurt ahead at a 5.9 per cent rate. What do US policymakers know that our own domestic policymakers have yet to discover?

In truth, they don't know very much more. The US numbers are "annualised". They express the quarterly growth rate as if it were to be repeated through a year as a whole. The actual percentage change on the previous quarter, consistent with the UK data, was 1.4 per cent. Admittedly, this is still a whole lot better than the UK managed, but the gap when properly measured isn't quite as big as the headline numbers suggest.

Delving into the details of the two releases, one big similarity is consumer spending where, in both nations, households remain lethargic. True, they are beginning to spend their money again but the pace is muted, reflecting what might be described as a new-found sobriety. Another similarity is inventories. Companies in both nations were either stocking less or, in some cases, rebuilding stocks, the sort of thing that always happens in the first couple of quarters of any nascent recovery, no matter what its eventual strength proves to be. Inventories often amplify the true underlying trend, at least for a quarter or two.

The big differences lie in investment and exports. Equipment and software investment has begun to pick up in the US, as have exports. Investment continues to decline in the UK, and exports, although growing, are rising at only about half the pace of those coming out of the US. This is puzzling. Sterling's collapse through 2008 should have given UK companies a big competitive boost yet exports are making only limited headway. One obvious explanation is the geographical mix of the UK's export markets. A lot of US exports go to dynamic parts of Asia and Latin America, but the UK's exporters tend to depend much more on continental Europe. Sadly for the UK, watching Europe grow is akin to watching paint dry. Being competitive is not just a story about exchange rate depreciation. You also need to export the right products to the most dynamic markets.

But before, I conclude that the US is doing a lot better than the UK, the data under discussion is all for the final quarter of last year. For the US, the new year has not been so encouraging. Two areas have suddenly looked decidedly wobbly. The first is housing, where both new and existing home sales have suddenly slumped, partly reflecting the distorting effects of the homebuyer tax credit, which helped to boost housing demand – temporarily, it now seems – in the second half of last year. The second is consumer confidence where, on the latest reading, consumers have suddenly become a lot more cautious. Even though there have been signs of improvement in the US labour mart, it's increasingly clear that US consumers continue to worry about their job prospects.

The early stages of any economic recovery are uncertain but, at present, the uncertainty is unusually high. Many of the fiscal policies introduced last year – housing tax credits, cash for clunkers and so on – have merely distorted the timing of household expenditures. Those who, in any case, would have bought homes or cars in 2010 brought forward their purchases into 2009, thereby flattering last year's economic numbers at the expense of demand in 2010. This applies not just in the US but *many parts of Europe. France succeeded in boosting car sales in the second half of 2009 only to discover that sales collapsed in January. At this stage, we can't be sure we haven't been staring at a phantom recovery.

For policymakers, these are awkward times. Often, people talk about recessions and recoveries, as if these were the only two separate economic states of nature. The world is much more interesting than that. We can have depressions, recessions, stagnation, weak growth, strong growth, productivity-led growth, deflation, inflation and all the variations under the sun. Thus we have Mervyn King, the Governor of the Bank of England, talking about the UK economy bumping along the bottom, seemingly suggesting that interest rates can remain on hold for a long time while, Paul Tucker, the Deputy Governor, warns of growing "supply-side" bottlenecks which might allow inflation to rise even in the absence of a decent recovery in demand.

It's worth going back to the 1930s debate between John Maynard Keynes and the Austrians. For Keynes, economies could settle at different levels of activity, from full employment through to the deficient demand associated with recessions and depressions. The losses associated with these periods of deficient demand could be corrected via government intervention designed to lift animal spirits, thereby bringing markets back to their senses and allowing full employment to be regained.

This story is central to those who believe that the world economy is on a sustained recovery path. Seen through Keynesian eyes, the recession was a failure of market forces associated with a collapse of animal spirits. All that's happened over the past 12 months is that, slowly but surely, those animal spirits have been revived.

For the Austrians, led by Friedrich Hayek, government (and central bank) intervention often made matters worse. Indeed, an Austrian take on the crisis would argue that the damage was done not during the crisis itself through a failure of animal spirits but during the earlier boom, a period during which central banks left interest rates too low, thereby distorting the cost of capital and promoting excessive investment in real estate. This "wasted" investment now means that the capital stock is less effective than it should be, lowering the economy's long-term growth rate on a permanent basis.

For a musical rendition of the disagreements between Keynes and Hayek, visit this Youtube site, www.youtube.com/watch?v=d0nERTFo-Sk . For a less musical version, it's possible to argue that, in a simple sense, both economic greats have something useful to say about the present crisis.

The Keynesian solution prevented a deep recession from turning into a hideous depression. Yet, from now on, the western world is likely to suffer a Hayekian constraint. We have, collectively, invested in the wrong areas of economic endeavour and wasted huge amounts of money. Whether the resulting debts reside with banks, households, the government or future taxpayers, the consequence is the same: even with signs of recovery, it will feel for a long time as though we are bumping along the bottom. Like it or not, we are heading into a new age of Austrian austerity. Keynes didn't have all the answers.

stephen.king@hsbcib.com

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