The Business Cycle Lives Again

SAMUEL BRITTAN, ECONOMIC VIEWPOINT

The US recession is more deep-seated than central bankers admit - but it may have benign side-effects in Europe

The Federal Reserve's emergency interest rate cut of January 3 was almost certainly triggered by financial indicators. There have been rumours about particular financial institutions but the widening of corporate bond spreads has been a fact, as has been the sharp, but perhaps temporary, narrowing since Alan Greenspan, Fed chairman, acted.

As for the real economy, it is no longer a question of when the US recession will begin but how long it will last and how far it will go. Private sector forecasters predict a drop in gross domestic product of about 0.5 per cent at an annualised rate in the first quarter of this year. But I am less sanguine about the sharp rebound most of them expect soon afterwards.

It helps, however, to look at the immediate data in historical perspective. In the depressed 1930s two views of the business cycle contended among economists. According to Keynes the trouble was underinvestment. The opposite, so-called "Austrian" point of view saw the trouble in overinvestment during the boom phase. (The name "Austrian" was a partial misnomer as the bastion of this theory was the London School of Economics.)

In any case, the exponents of that theory were dealt a body blow by their bad timing. During one of the worst depressions in modern history, a theory that stressed overinvestment did not stand an earthly chance. By the end of the 1930s, even most economists at the LSE had gone over to Keynes.

But a theory that may be inappropriate for the time it is put forward may have a lot to tell us at other periods.

The vigorous booms in the US in the last few years of the 20th century, and its recent crumbling, have the trappings of an Austrian-type cycle.

As a minority of skeptics has been pointing out for some time, there has been overinvestment in the US. It is not only stock market prices that have been too high. There has also been excess physical investment. It would be surprising if there were no excess capacity to work off.

The US readjustment could indeed be more difficult than that predicted by the Austrian theory. According to that theory, the investment boom is made possible by abnormally high domestic savings. But in the recent US boom - and, for that matter, in its weaker copy in the UK - there has been no squeeze at all on consumption, which has risen vigorously in the past five years. The savings to finance US investment have come partly from large budget surpluses, which count as savings in national income arithmetic, and also from a current payments deficit financed by inward investment.

Indeed, US personal savings have virtually disappeared. Because of the "wealth effect" generated by rising asset prices, Americans have felt that they could prudently consume more than they earned without eating into their financial resources. But once the stock exchange euphoria comes to an end the wealth effect disappears and people return to their normal saving habits.

Thus the US investment adjustment looks like being accompanied by a squeeze on consumer spending as well. The two forces would then have their usual multiplier effects on each other and on the economy. One mitigating factor is that real property values have held up better than equity prices, although if the recession continues this support could weaken. As it is, the recession is likely to be more obstinate than the optimistic central bankers' statements about a mere slowdown to 2.5 per cent growth this year.

What, then, should be the policy response? Clearly, to act promptly on signs of real weakening in the US economy rather than on prophecies of doom. But what should be the mix between monetary and fiscal stimulation? A benefit of further monetary relaxation is that it acts more quickly.

The offsetting danger of sharp interest rate cuts is that they could postpone the liquidation of the excesses of the recent boom and could even reinforce the idea -specifically disowned by Mr. Greenspan - that the Fed has the duty of supporting the equity market.

The case for acting on the fiscal front is that tax cuts have a more direct effect on consumption. But I cannot help being amused by the rush of Republican policy advisers, who previously proclaimed the utmost skepticism both about fiscal policy and about fine-tuning, to say that the prospective tax cuts are urgently needed to fight recession. In this they will be joined by Democrats who do not want to be accused of pushing the economy into a slump.

I have a lurking suspicion that the structural budget surplus is exaggerated by recent estimates and will melt away when economic cold winds force a reassessment of the arithmetic - as they did in Britain in the early 1990s and could do again. And tax cuts are less likely to stimulate spending if consumers suspect that they cannot be afforded in the long run and ultimately will have to be reversed.

How about the overseas impact? A US recession normally has its severest and earliest effects on the Pacific area and Latin America. But in Europe there may even be some benign aspects, at least in the early stages. Were it not for the cold wind from across the Atlantic there would in fact be a case for an increase in the UK's base rates. Domestic demand is still growing vigorously: the payments deficit is rising; and skill shortages head the list of business complaints.

The slowdown in UK growth at the end of last year is deceptive. As the National Institute of Economic and Social Research has pointed out, the economy has been "depressed by the effects of the rail stoppages and weak output in the oil industry. This does not indicate a general slowdown and suggests the (Bank of England) was right not to reduce interest rates".

By encouraging the dollar to fall, further US interest rate cuts would relieve the worries of European policymakers who claim that the euro is undervalued. Thus even the European Central Bank might at last stop worrying about inflation and move towards stimulus. If a weaker dollar means a stronger euro, UK manufacturing will benefit and the UK economy will become better balanced.

A prolonged US recession would be a different story. It would be likely to have a bigger effect on Europe through confidence and financial effects than conventional forecasting models, which focus on visible trade, suppose. But it is one thing to foresee a danger and quite another to act prematurely on the assumption that it has already occurred - as those most stridently clamouring for UK interest rate cuts need to remember.