Hamish McRae: Deficit of realism. America assumes a lot in its road map to recovery

Sunday 01 March 2009 01:00

The US economy is in an even worse state than we thought. The response to the stimulus plan signed off last week by President Obama was pretty negative, and the plight of the big US banks remains as dire as ever. But the sheer pace of the plunge of the economy, coupled with the extraordinary scale of the US budget deficit, may well change the profile of the global downturn. And if so, that will affect all of us.

The GDP figures for the final quarter of last year were revised down to an annual rate of 6.2 per cent, the worst for 26 years. But it is unlikely the decline can carry on at that pace for long, because the driver of the fall, a collapse in consumer purchases, is so sudden that it has to rebound. People can put off buying that new car for a few months but eventually it makes financial sense to use the amazing discounts on offer to replace the present one, particularly if the new car is more economical.

Also, the downward revision of the figures, which came out earlier in the month, was down to a recalculation of stocks. Since these were lower than first thought, there is less slack in the supply chain than originally assumed. Conclusion: the economy will doubtless have carried on shrinking in the first quarter of this year, but probably at a slower rate. That said, as you can see from the graph, the recession is now well embedded.

There are also no green shoots yet to suggest a turning point. There is, for example, very little sign of a recovery in the US housing market – in fact none at all. Inasmuch as you can generalise about such a vast country, US homes are pretty much back to fair value in terms of their affordability. But the uncertainty is such, and the overhang of unsold homes so huge, that prices are still falling. Confidence is lower than it was during the recessions of the 1980s, 1990s and early 2000s, as you can see from the other graph.

The question that arises then is whether the new US budget will change things. The boost is huge. The budget deficit is projected to rise to 12.5 per cent of GDP. That is higher than at any time since the Second World War. It is double the size, relative to GDP, of Franklin D Roosevelt's New Deal in the 1930s. It is larger than the fiscal deficits run by Japan during the 1990s, which is not an encouraging precedent since they pretty much failed – though arguably Japan's so-called "lost decade" would have been even more lost without them. Finally, it is even larger than the proposed deficit that our present Government plans to run here.

So what should we make of it? I suppose I fear this administration is making the same mistake with fiscal policy that the previous one made with monetary policy. Remember how the Federal Reserve cut US interest rates way below the rate of inflation to pump up the economy after the collapse of the internet bubble? It succeeded in boosting demand. People borrowed like crazy, savings plunged, the housing boom took off, and the economy recovered. But the growth was artificial and could not be sustained.

The argument at the time was that the impact was not inflationary, and that was right for prices were held down by the imports of cheap goods from East Asia. And the credit boom was not risky as the banks were able to spread their risks by securitising their debts. In any case those debts had AAA ratings. But the lack of inflation (and those AAA ratings) lulled people into a false sense of security and we all know what happened.

The argument now is that the loss of output from recession is so huge that it makes sense for the state to borrow to reverse it. You could say the economy is a bit like an airline or a hotel – the revenue from a seat or a bed not filled is lost forever. So better to borrow now, get demand up, and claw back the borrowing later. To some extent this must be right, provided the fiscal position is indeed brought back into kilter. President Obama's plan holds that the deficit will be back to 3 per cent of GDP by the end of his term. If that were the case, it might be just about acceptable. Trouble is, the assumptions on which this deficit-reduction profile are made look to me to be quite unrealistic. GDP growth next year of more than 3 per cent? Huh?

There is a further concern. This programme assumes the US government can finance it. Now at the moment the dollar is riding high, with government assets seen as a safe haven in the storm. The current account deficit is narrowing and the Chinese are perceived to have no option but to keep investing in the US.

So for the time being the deficit can be financed, or so it would appear. But the mood of financial markets is fickle and at some stage it will turn. There have been runs on the dollar before. You could envisage a nightmare scenario where the flow of funds into the US reverses, long-term interest rates shoot up, the US fiscal position fails to improve and there is a global dollar crisis. Even without that, the debts will be a burden for a generation. The seeds of the next downturn are being sown now.

Meanwhile the US banks still have to be nursed back to health. There has been a lot of criticism of the new US Treasury Secretary Tim Geith-ner, either for lacking clarity in his bank rescue plans or perhaps for rescuing them at all. Citigroup shares collapsed on Friday when the bail-out plans was announced. I really feel this is unreasonable. You cannot rescue banks well; you just have to rescue them well enough. It is now established that the major American banks won't be allowed to fail; the mistake made over Lehman Brothers won' be repeated. As a result the money markets are starting to function again, though not very well for that takes time.

So the necessary (but insufficient) conditions for an economic recovery are being put in place. Until credit is flowing, there can be no growth. You pump in money and it disappears; it does not feed through into demand. Given that lending ought to start again by the summer and given the sheer scale of the fiscal plan, it seems reasonable to expect some sort of bounce in the US come the autumn. But will it be sustained? I'm concerned it may not. So a new letter in the alphabet soup of recessions comes to the fore, the W.

You know the point. Will the recession, plotted in a graph, look like a V, a U or a W? A few months ago the probability looked like a shallow U. More recently, given the pace of the plunge, it has begun to resemble a V. But if there is a bounce in the autumn, followed by another dip through next winter, that will be a W. The real recovery will have to wait until well into 2010.

Of course this is speculation, but it seems plausible, and more plausible given what happened last week.

Eastern European economic freefall was not in the EU brochure

The run of success in Eastern and Central Europe has come to a halt and Western Europe is being asked to pick up the tab. As elsewhere there are two problems, a banking and an economic one. But there are two further twists. One is that huge borrowings in euros are being serviced in local currencies; the other that some countries are exposed to the problems of Russia and Ukraine.

On Friday the World Bank, the European Investment Bank and the European Bank for Reconstruction and Development combined to lend more than £20bn to finance banks and small companies across the region. But that is not nearly enough. The core of the problem is that people borrowed in euros to get a lower interest rate – a policy that seemed sensible at the time as the new EU members were converging fast on the eurozone. But their currencies have fallen by up to 50 per cent since last summer, vastly increasing the burden of debt.

If this is a problem for the countries concerned, it is almost as big an issue for some eurozone banks, particularly Austria's, which have debts that probably can't be repaid. It's Europe's equivalent of the US sub-prime crisis, made worse because a lot of the new member state banking services are provided by eurozone-based banks. (Mercifully this seems to be one banana skin that British banks avoided.)

The banking problem will be fixed but the economic one will remain. One aspect has been a sharp fall in demand from Western Europe, but the Baltic countries, Ukraine and to a lesser extent Romania have been hit by the mayhem in Russia. The inevitable result has been a fall in GDP and rising unemployment. So there will have to be further support, with the IMF and the EU stepping in.

And there is still the wider problem of the euro, which is being under- mined by fears (I think unfounded) of government defaults in Greece or Ireland. The region will recover,: but the path from here to there will not be easy. This was not in the EU brochure when these countries joined.

Join our new commenting forum

Join thought-provoking conversations, follow other Independent readers and see their replies

View comments