Sean O’Grady: Forget about 'V' for victory, this recession is more of a wobbly 'W'

Economic View

For those of us who believe that the recession is going to be W-shaped, now is a good time to take stock. W, remember, stands for "wobbly" – precisely what this recovery is turning out to be. Indeed you might even call it a "Wecovery".

So let's see. The first of our Double-Us is mostly behind us. You can understand how this might be mistaken for a V, and a V-shaped recovery declared. V for victory, indeed. That however is premature, even if the worst is behind us. The leading indicators have picked themselves up from the bottom, pointing to better times; manufacturing output has crept up, at last; and the National Institute of Economic and Social Research, with an excellent track record for forecasting, says that the economy grew in April and May, though marginally. The economy bottomed out in March.

Broadly speaking, in the first stage of recession we had the credit crunch shredding confidence, the banking system, trade and consumer and business spending. We also endured a savage but shortish episode of "destocking" – where retailers and manufacturers sold from stock as they adjusted to lower demand rather than placing new orders with factories and suppliers, exaggerating decline. Most of that is over, though it might be a mistake to believe that stock levels will bounce back like knicker elastic to where they were before: inventories cost money.

Which brings us to the second U in our W, the second downswing. In fact this is a shallower U than the first one, so our W is a bit lop-sided, if you see what I mean.

What will go wrong? The credit crunch, oddly enough. Businesses are still finding it tricky to get their hands on money to finance day-to-day activities and investment, and where they do the cost is spiralling. PricewaterhouseCoopers' debt advisory arm says that margins for corporate credit – in effect a banker's premium for the risk it thinks it is taking on – are 2 to 3 percentage points, high by historical standards. For the largest, soundest firms with direct access to markets things are opening up a bit: Tesco managed to get away a simple, mortgage-backed security last week, a landmark event – but it had to pay a handsome rate of interest for the privilege, even though the £431m bond was secured on a solid flow of rental income from Tesco stores. Equity markets are also more bullish – witness the 3i, Marstons, William Hill and HSBC rights issues. Some appetite for risk has returned. But highly leveraged private equity deals seem to be a thing of the past. And bank finance is hard to come by, which really matters.

When the foreign banks abandoned these shores, they left a hole that enfeebled domestic banks could not fill. The Bank of England cautioned last week that lending to UK businesses is at its lowest since June 2000. For non-property businesses, lending is actually contracting.

However, strange to say, the banks could – or should – be lending even less, and their comparative generosity now is simply delaying the effects of the recession: When that changes, as it inevitably will, the economy will be pushed down again – the second of our twin Us. For even though the banks appear to be in a better shape than they were – in the UK and US if not Europe – that is partly illusory, and where it is not illusory it is a problem: A problem, that is, because it means that they are rebuilding their margins, profitability and capital – which means they're charging business more for their money.

The illusion comes from the fact that anecdotal evidence from private equity specialists and insolvency practitioners tells us that, despite the overall image of stinginess, many of the banks are exercising forbearance – lending distressed firms even more cash to keep them out of the bankruptcy courts and, more to the point, minimising provisions and write-offs landing on the banks' balance sheets. Property companies are being especially indulged. The banks are in denial: Arguably, they are "supporting the economy", as the politicians have insisted, and saving jobs. This is simply putting off the painful restructuring that a company may need to survive, or its inevitable demise. Indeed, by extending a doomed enterprise's life the banks may be adding to the losses they will eventually be forced to own up to, and may even make the plight of the company concerned even worse. Either way, bankruptcies and unemployment will continue to climb.

A similar version of this misguided kindness may be being exercised by HM Revenue and Customs, believe it or not. As an unsecured creditor in an administration, the taxman is more than usually sensitive at the moment to pleas for more time. Politically, too, there are obvious pressures. In the pre-Budget report, the Chancellor announced the Business Payment Support Service. HMRC declares that it "has proved very useful to businesses suffering temporary financial difficulties and by 19 April 2009 over 110,000 agreements had been reached with businesses worth almost £2bn" – an average of £18,000 a pop. Very helpful, but unlikely to save every one of them and the others that follow them from retrenchment, restructuring or death. Pain postponed again, but pain that eventually also propels us down the second U in our W.

The third source of unorthodox and unsustainable corporate finance comes from the workers – who are co-operating by cutting wages and hours and generally easing up on managements (though the Tube and construction workers may not have got the message): That is very different from what happened in the last few recessions. The most extreme example is at BA, where the staff are being asked to follow the example of Willie Walsh, the chief executive, and work for nothing. Such magnanimity on the part of staff may be admirable, but it cannot last forever. Sooner or later, pay will have to return to normal, and when it does, more firms may be tipped over the edge.

When the banks, HMRC and workers run out of cash and patience, we will see a wave of bankruptcies and redundancies. It will be exacerbated by the trend to higher interest rates that will begin next year. The concept of "crowding out" may soon become fashionable again, as the state bids up the price of funds and leaves the private sector hungry. Inflation may spike. Then we should be at the bottom of our second U. The economy will have run out of sticks to beat companies with. By this point, the weak pound may even have yielded some export gains and a second leg of recovery can begin.

The last stroke of our W will thus be incredibly wobbly, but the real question is the one you might ask a child learning their alphabet: What comes after W?

Mud wrestling at the Mansion House apart, what if the Bank gets its toolkit?

Watching the shenanigans at the Mansion House last week, you could be forgiven for thinking how on Earth it came to be that the Governor of the Bank of England and the Chancellor of the Exchequer could end up in such public disagreement about the way forward for City regulation. Demure as they were, the pair were wrestling in the mud, intellectually speaking.

I got to wondering how the "macro-prudential toolkit" Mervyn King asked Alistair Darling to provide might work in practice. The rationale is simple and laudable; interest rates are best suited to taming inflation. In the earlier part of this decade, we had a credit boom coupled, unusually, with subdued inflation. Ramping rates up to deal with it would have wrecked the economy. So other tools are needed to curb the banks' excesses during a credit boom, things like requiring them to hold more capital in reserve, if they start getting frisky.

So, say Mervyn got his toolkit. How and when would he use it? In principle, it would be when the Bank's Financial Stability Committee judges that, for example, a world stock market bubble is getting out of hand, like the dotcom boom. Then again, the new European watchdog, the European Systemic Risk Council, might not agree. Neither might the US Fed, to be given that role by President Barack Obama. Then what? Regulation in one country?

Then again, the IMF, the putative global watchdog, might agree with the Bank of England. But the EU and US might ignore it. And what is to stop, in our wonderful globalised world, money leaking in or out of the UK in defiance of Mr King's Committee? And even if everyone in the G20 or the OECD did agree, what if tech stocks, or house prices, carried on spiralling? Mr King admitted that no one can prevent a market crash – but is that not the hope and expectation they are stoking up with the statutory duty to "contribute to protecting and enhancing the stability of the financial systems of the United Kingdom"? All very muddy indeed.