Hamish McRae: Cutting interest rates is fine, but it won't stave off a recession

One of the great surprises this year has been why the previous five rate cuts have not worked'

Today the US Federal Reserve is poised to announce another cut in interest rates in an effort to stave off recession in America. That is a racing certainty: the only issue is whether the cut will be by a quarter or a half per cent. Alan Greenspan, the Fed chairman, will explain that there is a danger of recession and reiterate the Fed's determination to meet the threat by cutting rates appropriately.

But it will fail. That is not certain, of course, but it is now odds-on that a US recession has just begun. That is the view gradually gaining ground both in the United States itself and in the financial markets here in London. For example in the States the National Bureau of Economic Research (NBER) warned that it is possible a recession began recently. It noted several factors including rising unemployment and falling industrial production, though it felt there was not nearly enough data to be sure. That negative view is supported by the Economic Cycle Research Institute, which argues that the indicators that define a recession have never been so bad without a recession occurring.

Here in London, the economics team at HSBC, which has consistently warned of the likelihood of a US recession, now reckons that as US companies slash costs, "this US recession will be deeper and longer than the consensus currently expects".

This is all taking America by surprise. As recently as April the NBER said that nothing in its data would prompt an inquiry as to whether the country had entered recession. And late last year the very US companies that are now sacking large numbers of their workforce were still reporting big increases in profits.

This raises three main questions. Why so sudden a collapse in demand? Can cutting interest rates and taxes head off a truly serious recession? And will American woes spread to the rest of the world?

One of the basic rules of economics is that things usually take longer to happen than you expect but then they happen more suddenly. That certainly happened with the long US boom, which looks like having lasted nine years. Partly as a result of the length of the boom, Americans forget what it was like to face a decline in demand. Call it the Mickey Mouse effect – you know, the cartoon character who is running along the ground and comes to a cliff. He goes on running in mid-air for a while, looks down and suddenly realises there is no ground underneath. Then he falls like a stone.

By last summer there was no ground under the US economy. Consumers were living on borrowed money; companies were living on borrowed money; indeed the whole economy, with its current account deficit of 4 per cent of GDP, was living on borrowed money. But they didn't look down. Now they have – or rather the companies have, for consumers are still spending. Profits have fallen at the fastest rate since the early 1990s recession, squeezed by falling demand and rising costs. In America, when profits fall, companies act: unemployment is starting to shoot up as they shed labour. And when people lose their jobs, or even fear losing their jobs, they too cut back. Expect that to happen now.

But can cutting interest rates help? Well, it must help a bit, but one of the great surprises this year has been why the previous five interest-rate cuts have not worked. Sure, there are always lags in economics but you would expect something to have happened by now. Besides, if five cuts do nothing for the economy, why should a sixth, or indeed a seventh or eighth?

There are three main explanations. One is that cuts in interest rates usually weaken a currency, but confidence in the main alternatives to the dollar, the euro and the yen, has been so dreadful that the dollar has remained very strong. So US export demand has been weak and imports have continued to compete effectively against domestic goods.

Second, lower interest rates usually boost the stock market, leading to a wealth effect: as people feel richer they tend to spend more. Had there been fewer cuts, the market would surely have been even worse, but they have been ineffective against the collapse of share prices of hi-tech companies.

Third, the cuts in short-term interest rates have not brought down long-term rates. In fact for all but the best-rated companies, long-term rates have risen. So firms face a cash squeeze: even if they wanted to invest, they would be discouraged by the rising cost of investment capital.

Eventually expect lower interest rates to do the job. The US is not in Japan's position, where rates are as near zero as makes no difference and the economy is still in recession. But do not expect good news fast.

So will the US recession spread? I am afraid it already has. It has spread to South-east Asia, which is the main supplier of components for US hi-tech products. Japan, for its own reasons, is almost certainly back in recession and the new government is warning of worse to come. So that is the world's largest and second largest economies in trouble. What about the third largest, Germany?

Germany has been a great disappointment. It has wonderful companies – it is still the world's second largest exporter after the US – but a structurally depressed economy. Until a couple of months ago most forecasters were expecting it to grow by at least 2 per cent this year; now some are as low as 1.1 per cent. That is not recession, though it is possible that this could strike Germany this summer. More likely, the economy will grow very slowly. But put at its most cheerful, Germany is not going to be a motor of growth for the eurozone this year.

Then there is us, for technically we are probably still a larger economy than France. We seem to be doing fine. Our economy actually grew faster in the year to end-March than had previously been estimated: 2.7 per cent against 2.6 per cent. France is also still growing quite strongly, as are Italy and Spain. But if economies one, two and three are in trouble, it would be naïve to think that numbers four, five and six are going to carry the show.

My guess is not just that this US interest rate cut will fail. So too will the next ones, for there will be more as the Fed relentlessly drives down the price of money. This is because cheaper money will not stop US companies in their determination to cut costs, which in turn means shedding labour. As they do so, US consumers will take fright. That great motor of the world economy will take a time out. The good news is that the same drive for efficiency that will deepen the recession will also create conditions for a revival. America will become leaner. Just as it led the world into the boom, so it will lead the world into recession, or something close to it. But then it will pull the world out.

And why didn't the great Alan Greenspan see this coming? I don't know – but I know he didn't spot the early 1990s recession either.