Stephen King: Don't be so sure rate-setters have secured recovery

Post-bubble countries take a long time to adjust and cyclical bounces may peter out

This week, I want to think the unthinkable. To date, policy-makers have been slapping each other on the back having apparently sown the seeds for lasting economic recovery. What, however, if these seeds have fallen on stony ground?

There are some potentially worrying signs. Consumer spending in the US appeared to ease back in the second quarter, hit by lower wage growth. Consumer spending remains relatively soft across most of Europe (with the UK an honourable exception). The markets continue to worry about company profitability. And, consistent with medium-term worries over the pace of economic growth, bond yields continue to fall as people switch out of equities.

Earlier in the year, there was a well-established view. The recovery in business surveys, the low level of interest rates in most countries around the world and the beginnings of a pick-up in world trade growth seemed to suggest the worst was over for the world economy.

Yet the world economy may still be suffering from the excesses built up in the late 1990s. There are a number of obvious areas of strain. The persistent falls in equities hint at a deterioration in the medium-term outlook for growth and profits. The renewed widening of the US trade deficit (reaching a record of almost $36bn in April alone) suggests the US economy has become overly dependent on the generosity of foreign investors. These investors, in turn, have started to tighten their belts, keeping their money at home and, thus, undermining the US dollar.

Of course, there are still areas of strength. Housing market buoyancy persists in the US and the UK. So long as interest rates remain low, so the argument goes, housing will offer support. Yet it is difficult to see how this argument can be sustained over the medium term. The more the equity bubble deflates, the more the effective cost of capital for companies will rise. As this hurdle gets higher and higher, investment spending will slow down. That may imply a persistent deterioration in medium-term growth prospects that, in turn, could undermine household income levels.

Faced with this kind of deterioration, consumers may begin to get cold feet about taking on more and more debt, even if interest rates are relatively low. If there is a vulnerability about future income growth – either through higher unemployment or, more likely given today's greater labour market flexibility, lower wage growth – consumers may think twice before taking out yet another loan based on nothing more than the changeable value of their home.

None of this need happen, of course. However, there are reasons for concern. First, some post-bubble countries take a long time to adjust. Faced with a large debt overhang, people may simply choose to pay off debt rather than spend. Second, initial cyclical bounces associated with lower interest rates may peter out if countries had overly-consumed or overly-invested in the first place. Third, only part of the bubble – in the US, the equity market – may have deflated so far. Should the housing market go as well, the post-bubble environment would look more worrying.

Under these circumstances, a lot of the standard assumptions about traditional cyclical recoveries begin to break down. The efficacy of monetary policy may be called into question. Lower short rates are absolutely fine so long as they can fall to levels that clear the financial markets. This, however, is not always guaranteed. In a situation where people have too much debt, there may be no level of interest rates low enough to persuade people to borrow more.

Fiscal policy may also not work terribly well. Looser fiscal policy always seems a sensible option in situations where monetary policy is ineffective but if people's savings have been hit by falling equity prices, they may choose to save, rather than spend, any tax cuts (look, for example, at Japan over the past 10 years).

A failure of traditional policies could lead to other stresses and strains. If, for example, the US recovery begins to fade, there could be more protectionist pressure following the example already set by the steel industry. And there would be a temptation to allow the dollar to decline in a major way, if only to ensure support for exports in a situation where domestic demand was on the ropes.

However, both policies could badly backfire. Protectionism would be a self-defeating act of desperation. A sustained dollar decline might help US exporters but, at the same time, could undermine growth in both the eurozone and Japan and could limit the scale of capital flows entering the US, arguably a key sustaining factor behind the scale of US growth during the second half of the 1990s.

Other countries could also face awkward choices. The eurozone, for example, could land in a fiscal pickle. France may be in the eye of the latest Stability Pact storm but other countries are also in awkward fiscal positions. For the most part, Europe's politicians are hoping a recovery in economic growth will boost tax revenues and, hence, move economies away from the supposed cliff-edge of the 3 per cent of GDP budget deficit limit. Faced with a growth shortfall, however, it could be touch and go for France, Germany and a few others.

Then what would they do? Caught between a rock and a hard place, they could either choose to raise taxes and cut public spending – breaking manifesto commitments in the process and leading to even weaker economic growth – or they could overshoot the Stability Pact targets, calling into question the credibility of the fiscal checks and balances supposed to prevent the emergence of free-riders within the eurozone.

Meanwhile, Japan could find itself in trouble again. The good news for Japan this year has been the evidence of a sizeable bounce in GDP reflecting a strong pick-up in exports. Yet Japan's history over the past 10 years has been a case of one step forward and three back. Japan's big cyclical advantage is its close relationship with the technology cycle in Asia but, ultimately, of course, this benefit has meant little over the last decade.

Ultimately, although the cyclical bounce so far this year has been encouraging, there are still puzzles surrounding the pace and durability of the recovery. The falls in stock markets, the dependency of growth on the housing market, signs of trouble for the dollar: all these things provide potential threats to the sustainability of economic growth. Although policy is currently supportive for growth, it may ultimately be the case that the legacy of the late-1990s bubble will serve to generate only a hesitant and fragile economic recovery.

Stephen King is managing director of economics at HSBC.