Risk & Economy » Regulation » Economics: Tissue anyone?

The broad outline of events is very familiar. A previously robust economy is
slowing sharply, the housing market is in freefall, unemployment is rising,
consumer confidence is evaporating, government finances are fragile and
corporate profitability is under pressure. If that is not enough, there’s the
credit crunch and systemic weakness in the financial sector all conspiring to
create the perfect storm.

Yet not everyone is convinced the outlook is unambiguously bleak. GDP for Q2
was surprisingly strong, the currency has been strengthening and business
opinion surveys suggest the low point has been passed. However, opinion on where
the US economy goes from here is divided.

What happens to the US matters greatly to the UK, for several reasons. Not
only is the US still our single largest export market, but the substantial
profits and dividends earned by British companies on their American investments
have made a substantial contribution to our balance of payments. Both depend on
a buoyant US economy. And, since the two major Anglo-Saxon economies have had
much in common in recent years ­ more so than the UK has had with Europe ­ the
extent and length of the slowdown across the Atlantic may have some lessons for
UK policymakers.

Events in the US have been running a little ahead of the UK, but there, as
here, it has been the personal sector that led the economy up and is now taking
it down. Having loosened policy after the dot.com bust and 9/11, by cutting
interest rates to 1% and reducing taxes by 5% of GDP, the Bush administration
ensured that annual growth from 2003-06 averaged 3%, much of it based on
consumer spending and the housing market.

As inflation began to edge up, the policy was reversed and interest rates
rose ­ 17 times, in all ­ to 5.25%. Not surprisingly, the heavily indebted
consumer retrenched and the housing market nose-dived, taking with it several
heavyweight financial institutions, including Fannie Mae and Freddie Mac.

For much of 2008, analysts have predicted a technical recession in the US,
but the inconvenient truth of the data kept spoiling the argument. The annual
rate of GDP growth in Q1 was just 0.9%, but in Q2 it bounced back with a robust
3.3%. Most of this (3.1%) was down to international trade, a surge in exports
and a drop in imports. The increase in domestic demand was just 0.4%, despite
the huge tax cuts. This ‘rebalancing’, helped of course by a weak dollar, is
exactly the sort of adjustment the Monetary Policy Committee wants to see in the

Even though the Fed said in June that “the downside risks to growth have
diminished somewhat”, pessimism still prevails about short-term prospects.
Stateside unemployment has risen by 2.2 million in 12 months (to 9.4 million or
6.1% of the labour force in August), consumer price inflation is a concern (it
had climbed to 5.6% in the year to July), while personal disposable incomes fell
in June and July. And, of course, the recent strengthening of the dollar will
make it difficult to sustain the recent export growth, particularly when much of
the rest of the world is slowing.

It is easy on the UK side of the Atlantic to underestimate the flexibility,
robustness and resourcefulness of the US economy. Moreover, growth traditionally
picks up in presidential election years and this could yet boost confidence,
whatever the outcome.

But the balance of the argument still seems to favour the pessimists.
Although a recession will probably be avoided, the US is likely to have sub-2%
growth this year and next.

All the usual numbers point to a classic ‘on-the-one-hand… but-on-the-other’
argument. But this time, the usual numbers have to be over-ridden largely
because this is not just another swing of the cycle. On top of the domestic
spending squeeze, the US is grappling with the biggest housing market collapse
for a generation, and associated banking sector problems.

The rate of decline in the influential S&P/Case-Schiller (house price)
index might only now be starting to slow, but the cumulative fall in house
prices has exceeded the 30% recorded in the 1930s Depression. Factor in the huge
problems to the banking system caused by reckless mortgage lending, and it is
clear that this is not just another downturn.

Much of what has happened in the US is echoed in the UK, not least the
squeeze on consumers, the stalling of the housing market and the credit crunch.
Where the US has been different, and why it should avoid a recession, is the
speedy response of its policymakers. When the problems emerged, interest rates
were cut, and cut aggressively.

The authorities took the view that growth and jobs were a higher priority
than inflation and, from 5.25%, the Fed reduced rates to just 2% in seven
months. Now that oil prices seem to be falling, there is an expectation that the
MPC (belatedly) will take a leaf out of the Fed’s book, which is why a Bank Rate
of 4% by end-2009 (and even less according to some forecasters) is now on the