Interest rates won't be to blame for this slump

This time neither inflation nor the balance of payments has got out of control
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The Independent Online
ONE SAFE assumption: as and when the US economy goes into recession the cause will not be over-high interest rates. Another slightly less safe assumption: ditto UK.

The two new pieces of news on the interest rate front over the last 48 hours are the cut in US interest rates and the clear indication that were the British economy to move into recession the Bank would be prepared to cut rates sharply.

The cut in US rates was widely expected, and to some extent was already "in the market". Nevertheless it cheered up US equities, and for that matter Asian equities too. What the markets were seeking was a signal that the Federal Reserve would keep pushing on rates if there was real justification to do so - a signal that they felt they received.

The UK indication came in the Bank of England minutes, explaining the rationale for the last half-per-cent cut in rates here. At the time the popular reading was that though the direction of rates in the UK would clearly be down, the Bank committee would err on the side of caution.

Some of us read the decision differently, seeing the Bank being prepared to respond as aggressively on the downward swing of rates as it had on the upswing. The minutes seem to confirm this view. Yesterday, spurred by weak retail sales figures, the markets were beginning to think of another interest rate cut before Christmas.

But if rising interest rates (or even unnecessarily high ones) will not push us into recession, what else might do so?

All post-war experience of the economic cycle has been that the move from expansion to contraction, from boom to slump, has been the result of rising inflation and the subsequent need to tighten policy to correct it.

In the UK we called this stop-go: after a few years of strong growth, inflation would rise and the balance of payments gap would widen. A rise in interest rates would help choke off inflation (though it took a while to take hold) and would support sterling. The dual impact of higher rates and a stronger pound would, however, push the economy into recession.

This time neither inflation nor the balance of payments has got out of control. In fact, were it not for the odd impact that higher interest rates have on the way the retail price index is calculated and the surge in taxation on consumer items like petrol, our inflation rate would be below 2 per cent.

The balance of payments was in surplus last year and may turn out to be in surplus this one. There is an imbalance in the US, where inflation has been held down partly by falling commodity prices, but more by the surge in cheap imports. But not here.

So what will stop the US boom? Aside from government spending there are three main components to demand: consumption, private sector investment and exports. Taking these in reverse order, US exports have been extremely weak this year, devastated by the fall in demand from east Asia. (The September trade figures, out yesterday, showed a slight narrowing of the deficit, but this was the result of declining imports, rather than any improvement in the export trend.) So do not expect exports to be a significant source of demand through next year. Things are more likely to get worse than better.

Investment? Investment in the US has risen sharply over the last four of five years, as companies have upgraded their IT and telecommunications systems.

Interesting question: have US companies invested too much? To most Britons, schooled in the notion that more investment is a wonderful thing, it might seem odd to suggest that too much is as bad as too little. If, however, you look at Japan, there is a very clear case of over-investment: factories building things people don't want to buy, bridges going nowhere, rail projects which will never repay their capital costs.

The US has not over-invested on anything like the Japanese scale, but some parts of the economy may have invested on the assumption that growth would go on for ever, and will therefore be gravely disappointed if it does not. Further, if company profits come under increasing pressure, as seems to be happening, paring investment budgets is one speedy way of improving the bottom line. Result: investment is likely to weaken rather than strengthen.

Finally consumers: as has been noted here and elsewhere, the US family has become a dis-saver for the first time since the 1930s. What I had not noted, however, was a point spotted by the economics team at ABN-Amro: the extent to which private sector cash flow has suffered over the last couple of years.

The graph shows what has been happening to that. Note that the earlier periods when private sector cash flow has dropped to zero - in 1979 and 1990 - led to recessions, and that the present deficit is the largest on record. So do not expect the consumer to sustain US demand indefinitely.

What is the conclusion from all this? Simply that our post-war experience that rising inflation forced central banks to bring expansions to an end because they had to raise interest rates may not be relevant to the present situation.

In the nineteenth century one of the typical ways in which expansions ended was the effect of the investment cycle. As demand rose, output was increased to meet it; after a while all the slack was taken up and new production facilities developed; investment demand helped sustain growth. Then all the new production came on stream just as demand turned down, pushing the economy into a slump.

I'm not saying that it will necessarily be the investment cycle that kills the US expansion. What is clear, however, is that while the things that have brought recent cycles to an end are not present this time, there are other things that can stop this one, both in the US, and in a rather different way, here. In the States, the fact that American households are facing the most serious cash squeeze for nearly 40 years is one reason for profound caution.