Hamish McRae: America could lead us into recovery but then back into intensive care

Sunday 08 February 2009 01:00

We are following the US. We followed it on the up with a housing boom and a borrowing binge of broadly similar scale. Now we are following it on the down.

We are alike too in the way we are meeting this challenge. We are both recapitalising the banking system in one way or another. We are following a similar path on interest rate policy, driving rates down as low as makes no difference. And we are adopting the same approach to fiscal policy, pushing the deficit up towards 10 per cent of GDP. Here the main difference is that thanks to the fact that the new administration is only just being put together, we don't yet know the detail of US policy.

So it is reasonable to expect that our economy will follow pretty much the same path as the American one, though perhaps a few months behind. The same goes to some extent for the rest of the developed world, of course, but the parallels with the US are perhaps more marked for us than other countries: our financial structures are similar, our consumers equally dependent on credit.

This is a good lesson for those of us, including myself, who felt that China and India and the other emerging economies would help pull the world through the downturn. Yes, they will keep growing and the overall numbers of the world will not be as bad as they otherwise might have been. But the plain fact is that the US is still the world's largest economy and that therefore no sustained recovery can take place without it. You could even say that since the problem started there, the solution will have to come from there too.

There are two questions to be answered in the US economy. One is, how bad is it? The other: is enough being done to fix it?

On the first point, I'm afraid there is very little sign yet of it bottoming out. As far as real living standards are concerned, things have improved since last summer, largely because of the fall in fuel prices. There is more money for people in secure jobs. But unemployment, always a lagging indicator, is still climbing. In the last three months of 2008, employment was falling by more than 500,000 a month. The jobless total has come up from less than 5 per cent a year ago to 7.2 per cent and could be close to 10 per cent by the end of this year.

Against this sort of onslaught. the US consumer – along with the Chinese economy one of the two great engines of global demand in recent years – can't help. This first quarter, right now, is off a cliff. The economy is forecast to contract at an annual rate of over 7 per cent, which is dreadful.

The more encouraging point is that if an economy goes down this fast, it will tend to bounce. The initial recovery at least will be quite sharp.

There is a common-sense explanation for this. At the moment people have frozen. You don't spend any cash you don't have to, particularly on big-ticket items. New car sales are down 40 per cent or more, with all the knock-on impact for Main Street.

But sooner or later that car has to be replaced. The dealer is giving wonderful deals. Cheap credit is starting to flow again. Maybe there are vehicles that give better fuel economy. So it makes sense to replace the vehicle, and the very fact everyone has frozen means they unfreeze at the same time.

Apply this in macro-economic terms and you can see a resumption in growth by the end of this year, and that will happen almost irrespective of the Obama administration's huge planned stimulus for the economy. That is a longer-term thing. If you try and boost spending by cutting taxes, you can put the extra demand into the economy straight away. If you do it by increasing spending on projects, it takes a few months to come through. Most of the plan now before Congress works on the spending rather than the tax side.

So the (very rough-and-ready) answer to the first question is: very bad but it will get better later this year.

So is enough being done about it? Or alternatively, are the right things being done about it?

I think one has to accept that policy is never perfect; if it were, we would not be where we are now. So the question is more whether policy is good enough to enable the normal adjustments of the market economy to take place in an orderly way and with as little damage as possible to economic wealth and society's structure. You have to get the economy moving, protect the weak, yet also ensure the recovery is sustainable. The previous administration, faced with the prospect of recession in early 2001, was successful at the first, not very successful at the second and very unsuccessful at the third.

The honest response to the question is that it is too early to say. The interest rate shots have all been fired, so the focus now is on the nature of the non-conventional monetary measures (what-ever they will be), the continuing banking rescues and the fiscal package now before Congress. There is not much that can be said about the first two, except to observe that money will be pumped into the system somehow or other and that another bank collapse along the lines of Lehman Brothers will not be allowed to happen. As far as the Obama package is concerned, it is not yet in its final form, but it will be huge – far larger relative to the economy than Franklin Roosevelt's New Deal and larger in fact than anything a US government has done in peacetime.

I find this troubling. I worry that the new administration will be making the same mistake with fiscal policy that the last one made with monetary policy. Yes, it will take over from the initial bounce noted above and sustain growth through next year. Yes, it will in some measure protect the people disadvantaged by the recession. But the problems that will be built into the US fiscal position will hang over the country for a decade or more. Worse, they may destabilise the whole world economy.

It looks as if the US government will be borrowing the equivalent of 10 per cent of its GDP, or something close to it. We have had experience of excessive US borrowing in the past. It was what undermined the Bretton Woods fixed exchange rate system. It led to a dollar collapse in the 1980s. By contrast, during the long boom of the 1990s, it pulled back from excessive borrowing, and one has to hope that as growth returns so the excesses of this package will be rolled back.

And us? We too have a dreadful fiscal position but let's not think about that now. While it is hard to see any growth until 2010, maybe well into 2010, that the US should have begun to pull upward by the end of this year is encouraging. You know the adage that when the US sneezes, Europe catches a cold. Well, when the US starts to feel a bit better, we will start to recuperate too.

The power of words: what part did City scribes play in boom and bust?

Are financial journalists to blame? Last week saw a few of our number before the Treasury Select Committee, a relatively unusual occurrence. While there was none of the drama expected this week when leading bankers, including Sir Fred Goodwin of RBS fame, face MPs, it is right to question ourselves about our role in the events of the past 18 months.

Our instinct is to think not. We are not important; we only do words; we don't decide anything. But that is perhaps disingenuous as those words do sometimes change things, I would hope for the better. As to if we are somehow responsible for what has happened, the charge divides into two. One is whether we warned sufficiently of the fragility of the boom on the way up; the other whether we exacerbated the recession as it happened.

On the first, I think our performance is mixed. We certainly warned about the unsustainability of public finances and there was a lot of comment about overvalued house prices. The trouble with the latter was that the loudest warnings came too early and lost credibility. We also warned that there would be a downturn, though we may have underestimated its magnitude, and we saw the dangers in the growing financial complexity. Where we failed was in missing the fragility of the big institutions. There were warnings about hedge funds, but hardly any about the big banks. We believed the assurances of boards and regulators, and that was wrong.

On the way down I suggest we have done a little better. There is the specific charge that Northern Rock stories led to the run on its deposits, but the markets decided it was bust before depositors. There is, on the other hand, the charge that we encouraged people to invest in Icelandic banks because they offered the best rates – a mistake, as it turned out.

As for the bigger issue of talking the recession up or down, there has been widespread comment, which on balance has been more on the button than the PM or Chancellor. School report? Could try harder.

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