The `R' word will return to haunt next President

Hamish McRae in Chicago One is struck by the contrast between the strength and quality of big corporations and the financial fragility of many families
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The catch-phrase, "It's the economy, stupid," seems more appropriate to this US presidential election than to the last. For the strength of the economy - very evident here in Chicago and the Mid-west - seems to be President Clinton's strongest card. The ill-temper of the electorate seems to have faded, or rather the "winners" in the economy seem confident that they will continue to do well, while the "losers" won't vote.

But from an economic point of view perhaps the most interesting question is whether the surge of popular support for the incumbent marks a high point in US economic self-confidence. Put more strongly, could the election itself signal the end of the boom?

That is not to suggest a causal link between politics and economics: simply to say that there are obvious signs the US economy cannot continue on its present trajectory. It must slow down and the question is whether it will do so gently, or whether there will be some discontinuity or shock.

A few weeks ago the US financial magazine, Barron's, ran a story warning about a recession in the middle of next year - the "R" word is being discussed in the press. Foremost among the reasons for concern is expansion's sheer longevity, the third-longest this century.

Other causes for unease include the level of share prices (of course), and the level of consumer debt at around 80 per cent of income. Consumers make mistakes, for the level of default on this debt is at record levels, too.

At any rate, the first half of the new presidency will be dominated by the "R" word: concern about the next recession. The economic forecasters are sketching two broad outlooks. One is that next year or 18 months will see a period of slow growth, say 2 per cent. There has been evidence that the economy has been slowing in the last two months: the housing market has slipped, with a fall in new home sales; exports, while growing, have been curbed by the rise in the dollar since the spring; other leading indicators of the economy which US economy-watchers examine, like the Chicago Purchasing Manager's Index, have been falling in recent months, suggesting less buoyant expectations within manufacturing industry.

Perhaps most importantly, employment growth (what Americans call non- farm payrolls) seems to have tailed off, and unemployment, at what to European eyes is an enviably low 5.2 per cent, may hold at that level, rather than fall further. It may be possible to squeeze unemployment lower still, but it must be close to the level at which wage inflation will start to show through.

This first group of economy-watchers takes the view that these figures show a sufficient slowing of the economy for there to be no need to increase interest rates by more than a token amount in the next few months. Result: a soft landing.

The second group looks at the same numbers but sees a different outcome. They think that wage inflation will become an increasing concern. The year-on-year rise in hourly earnings may reach 4 per cent, which would cause alarm in the Federal Reserve. They think that strong wage growth will underpin consumption and that this will start to show through in greater inflation. Eventually, they expect that the Fed will be forced to tighten policy, and some argue that a small, early dip into recession next year will be safer for the long-term health of the economy than delay in increasing interest rates - and perhaps a deeper recession in 1998/1999.

It would be nice at this stage to give a judgement as to the probability of recession next year - whether the optimists or the pessimists are right. But nobody can know. Further peering into the mass of economic data that the US economy generates makes things worse, for the volume of short- term information make it impossible to see the longer-term trend. But two things would strike the European visitor to the US at this time. One is the contrast between the quality and financial position of large US corporations, and the financial fragility of the position of many US families. The other is the assumption of continued financial stability: that the low-interest, low-inflation, steady growth world will continue.

The contrast shows in the difference between company indebtedness, half its level relative to profits compared with 10 years ago, and personal indebtedness, 50 per cent higher than it was then and at an all-time peak. While companies have cleaned up their balance sheets, people have not. So there is a very robust company sector able to cope with tough times, but individuals or families who run their affairs in a much less prudent manner. Individuals say they are concerned about insecurity when questioned in polls, but act as though they are not.

The worry, therefore, is that if there is some unexpected shock such as a rise in short-term interest rates or a sharp fall on Wall Street, companies will be fine, but people won't. A rise in short-term rates in the States would not hit the housing market as it would in the UK because mortgages are not so closely linked to short-term interest rates. But consumer borrowing is linked and so a rise would have an enormous impact on that. Further, a large proportion of personal assets are in mutual fund accounts, which people use as bank accounts. Imagine having most spare cash held not in a building society or bank, but in a unit trust.

The other odd feature is the assumption of stability. Britons know the pound can plunge and that interest rates can go up as well as down.

In the US, perhaps particularly in the Mid-west, it is different. The economy carries on regardless of what happens in Washington.

The continued competence of the Fed is taken as read. Maybe this is a function of the central bank having a fair measure of independence, or the widespread assumption that the result of today's election will be the continued balanced ticket - a Democrat president and a Republican congress.

But it may also be that Americans have forgotten about economic shocks. The last four years have seen uninterrupted, steady growth with very little signs of inflation. This election may not mark the end of this slow boom, but it would be absolutely astounding were there to be another four years like the last.