Stephen King: Stagnation rather than recession is stalking the US economy

Neither the US corporate sector nor the household sector are in a position to lead recovery

Going on holiday in the second half of July was, after all, quite a wise thing to do. When I came back, markets were at roughly the same levels as they had been when I departed. The intervening traumas completely passed me by. In fact, I only encountered one obvious market-related discussion in France: Sophie, my four-year-old daughter, appears to be turning into a eurosceptic, declaring that the coins in France were only "chocolate money".

Meanwhile, although the markets may have survived a particularly volatile patch, the economic news has generally deteriorated. The optimism seen in the first half of the year, based on strong recoveries in the majority of business surveys around the world, now appears to be on the wane. The US Institute of Supply Management survey – a barometer of manufacturing performance – has fallen back sharply (see my first chart). German manufacturing appears to have hit a bit of a brick wall and unemployment has risen further. The UK saw a catastrophic fall – hopefully partly related to the temporary impact of the jubilee celebrations and the football World Cup – in industrial output in June.

If you're an optimist, you might be inclined to believe that these are just the growing pains of a normal recovery. After all, most recoveries are rather unstable affairs, a bit like watching a drunken man attempting to climb a flight of stairs: one step back for every two steps forward. The peculiarity of the latest data, however, is that the message is so consistent from one country through to another. Is there now a danger that our drunk has slipped up altogether and is now lying at the bottom of the stairs enduring a particularly nasty hangover?

There is a relatively straightforward way to think about this issue. The size of the hangover often depends on the extent of previous excess. And, whether we like it or not, the second half of the Nineties amounted to a wild party, fed on any amount of both legal and illegal substances. No wonder that people are finding it difficult to recover. Last year's interest rate cuts – the equivalent of a sustained dose of paracetamol – might have helped ease the pain for a short period, but the danger is that our economic patient is now suffering far worse: blood poisoning, liver damage and all manner of other nasty things.

The reason for worrying about this is the lack of significant fundamental recuperation shown by our economic patient since the onset of recession. We now know – on the back of recent benchmark revisions – that the US recession last year was both deeper and longer than originally estimated. What is still unclear is whether last year's downswing has really removed the damage caused by earlier excesses.

Recessions, after all, are often considered to be cleansing processes, whereby people pay back the debt they raised in earlier years and whereby they try to improve their balance sheets to provide a base for renewed economic growth. Even though a lot of investors have been taken to the cleaners, it is not at all obvious that the US economy as a whole has emerged newly refreshed, even if a lot of dirty corporate laundry has been aired in public.

The problem is associated with the level of borrowing still taking place within the US economy. The second chart shows the extent to which each main sector within the US economy has been either borrowing from, or lending to, the other main sectors. Movements within these "sectoral balances" give clues with regard to the health and cyclical position of different parts of the economy. I should stress that they are no more than clues. Because sectoral balances are accounting concepts, movements should not, in themselves, be associated with any causal inference. Nevertheless, the patterns generated around previous recessions give some idea of the typical adjustments that take place.

Two definitional points should be noted. First, the sectoral balances should add up to zero (although in practice measurement error sometimes prevents this from happening). Second, the rest of the world sector is simply a measure of the extent to which the rest of the world is either borrowing from, or lending to, the US. In other words, the external sector balance is simply the inverse of the current account deficit (or surplus) within the balance of payments.

In the chart, recessions are indicated by the grey bars. There have been quite a few over the past four decades. They are useful in pinpointing the ways in which borrowing and lending changes between the sectors. The most obvious point to make is that government finances invariably deteriorate – becoming more negative – during recessions: this simply reflects cyclical downward pressure on tax revenues and cyclical upward pressure on some items of public spending such as unemployment benefits and may also reflect the operation of the so-called "automatic stabilisers".

Most recessions are also associated with a significant retrenchment from both households and corporations, with either less borrowing or more saving out of current income. This is often the result of aggressive monetary tightening designed to deal with other problems, notably the need to bring down inflationary pressures. But there are plenty of other reasons for retrenchment. Japan's retrenchment in the Nineties had little or nothing to do with inflationary pressures. Instead, the need to save more, to spend less and to pay off debts reflected a combination of earlier massive asset price over-valuations and, latterly, an inability of the Japanese economy to stage a sustained recovery in economic growth. Low interest rates were, in themselves, no cure for the earlier wild party.

And here lies the problem for the US today. The US has been through recession. It has cut interest rates to generate recovery. Yet neither the corporate sector nor the household sector are in a position to lead recovery. Fiscal policy may help for a while but, ultimately, consumers need to save more than before because of the losses they have so far experienced and companies will need to save more if they are going to be able to fund their ailing pension schemes.

These changes in savings behaviour may lead to other negative effects. So far, housing has been well-supported, a direct result of persistently falling short and long-term interest rates. But if consumers and companies ultimately choose to rebuild their savings or pay off their debts, it is difficult to see why the housing market will continue to remain a source of strength: put another way, house prices may rise as part of an asset allocation shift out of equities but a failure of economic growth to rebound threatens the value of all real assets, whether it be equities or property.

Ultimately, the sectoral balances suggest that the key problem facing the US economy – and, for that matter, the global economy – is not so much the possibility of a "double-dip" recession. That would be more likely to happen if, for example, there were to be an aggressive tightening of policy, a very remote likelihood at this stage. Instead, the main problem facing the US is an inability to stage a decent recovery. With none of the key areas of private sector activity in a position to take advantage of interest rate cuts, the danger is not so much one of renewed recession but, rather, one of economic stagnation. Under these circumstances, the light at the end of the post-bubble tunnel becomes very dim indeed.

Stephen King is managing director of economics at HSBC.