Terra Firma

It started quietly in the US housing market. Over-optimistic bankers had lent to people who could not really afford to borrow. Financial authorities and politicians were quick to point out that this was a little local difficulty. But it wasn’t: it turned out that the mortgages had a pyramid of sub-prime debt on top of them. But then this was claimed to be a problem for some US banks. The world economy was fine. But it wasn’t: banks in Europe were in trouble too. Northern Rock collapsed, and problems were revealed in German and Spanish banks too. The optimists then argued that Northern Rock had a flawed business model and, anyway, the effective nationalisation of retail deposits would solve the problem. It didn’t. Now it is finally widely acknowledged that we have the real prospect of recession.

For all the focus on financial markets, the underlying economic issues are in the real economy, and that is because the origins of what has been one of the longest booms in the history of capitalism were real. The 1980s and 1990s witnessed a major period of technical change – one that in the process fundamentally changed the nature of production and exchange, and consumer behaviour. Like railways in the mid-nineteenth century, and electricity in the 1920s (and cars and air travel after the Second World War), IT and the Internet profoundly altered the very nature of economic activities. And like these previous transformations, "irrational exuberance" and "animal spirits" based upon a new optimism carried markets with them. It could only get better – hence, why save when assets would be worth more tomorrow on the basis of endless economic growth? The business cycle had, it was widely believed, been abolished.

THE BUSINESS CYCLE IS NORMAL

And of course, it hadn’t. The business cycle is a normal part of capitalism. The booms are the creative bits of capitalism; the busts are the destructive bits: creative destruction is how it works. Optimism and exuberance spur on businesses to create new ideas, concepts and products. The great Internet boom has given us Microsoft and Google. The recessions cull out the dross.

History has not been abolished yet, and the current downturn is just part of the normal pattern of the great expansion of capitalism and markets which has been going on since the Industrial Revolution. But whilst part of a general pattern, each cycle has its own characteristics, and the nature, form and duration of a recession depends upon the nature, form and duration of the excesses which preceded it.

The great boom of the 1980s and 1990s had several peculiar features, the most notable of which was the associated financial liberalisation. This in itself led to much innovation and added greatly to economic efficiency. But it also allowed a level of gearing on a new and unprecedented scale. For some, the financial backdrop has led to a reinforcement of the idea that the business cycle is a primarily monetary phenomenon, and that since its cause is monetary, therefore so is its cure.

It is a short step to then argue that the business cycle can effectively be abolished through independent central banks and judicious monetary policy – and now, that a recession can be avoided by lowering interest rates. It is a seductive argument, but in its strong form it is wrong. Monetary policy obviously plays a part, and governments and central banks can exercise some control by setting the interest rate. But it is a mistake to leave out the real effects – and indeed it is these real effects which now matter.

The great late-twentieth century boom came to an end in 1998/2000. A recession was probably long overdue, and it would probably have followed the defaults of 1998 and the stock market crash of 2000, had it not been for monetary policy. Real interest rates were dropped to near zero in an attempt to prolong the economic cycle, which indeed they did, but only at the price of a much bigger crunch later. What monetary policy after 2000 achieved was a major jump in consumer and government indebtedness, and of course a further upward twist in the housing market. It also further exacerbated the world trade imbalances. Thus, with the cycle due to turn for fundamental real economic reasons at the end of the last century, the effect of monetary policy was to buy time – but at what now will turn out to be a very considerable cost.

WHAT WILL HAPPEN NOW?

That cost will be reflected in the real economies, notably in the US and the UK. The US matters to the world economy, of which it comprises about 25 per cent. The UK’s role in the world economy is much more modest, and the impact of its downturn will be largely domestic in effect. The reduction in house prices in both countries will result in a fall in consumer wealth, and that in turn will lead to lower spending and higher savings. Domestic demand will fall, possibly quite substantially. Consumers will no longer drive the economy.

A fall in consumer demand might not matter to aggregate demand if other components go up to compensate. For the US, the devaluation of the dollar should aid export industries, though it will depend on other markets remaining buoyant to buy US exports. This however takes time, and given the US’s size, the internal recession is bound to spill out to the world economy. And in the meantime, the US itself will have to adjust to the lower standards of living implied by a fall in the dollar, as well as the inflationary consequences of a falling dollar. Though these inflationary pressures will be partly offset by the reduced domestic demand, there is the further complication of monetary policy to bear in mind. It is not at all clear that the Fed’s aggressive cutting of interest rates will be entirely benign.

For the US, this will then be a tough period. But it will also be a much rockier one for the rest of the world too. China’s industrial miracle is heavily export-based – and in particular exports to the US – just as the earlier Japanese miracle of the 1970s and 1980s had been. A falling dollar has serious implications for China, exacerbated in its case by rising domestic inflation. The next few years may change the conventional wisdom of a perpetual continuation of China’s double-digit growth.

For the UK, this turn of the business cycle looks bleak. Not only is the UK more exposed on housing than even the US, and every bit as dependent on consumer demand, but it is also exposed proportionately much more on energy and on finance. The golden North Sea oil and gas years are over, when the UK for the first time in the twentieth century had no serious balance of payments problem. Now it has the largest external trade deficit as a proportion of GDP of any developed country – and that is in the context of only a slight energy deficit. As the North Sea runs down, this contribution will get much worse – especially with the dash for gas in electricity generation.

Added to the external deficit problems is the UK’s reliance on services and especially finance. The City of London contributes very significantly to GDP, and this is the sector most vulnerable in this particular recessionary context. What’s more, the City props up the balance of payments, so if it contracts, it will affect both the internal and the external positions.

Given these weaknesses, it is not surprising that the UK is likely to go down the devaluation route – like the US. However, like the US, inflationary pressures will correspondingly increase, and it may prove very difficult to aggressively lower interest rates in such circumstances – from their current very high levels by international standards.

LIGHT AT THE END OF THE TUNNEL

In the short term, the outlook is indeed very gloomy. But the adjustment is long overdue (since 2000 at least). Put simply, we have been consuming at an unsustainably high level on the basis of the irrational exuberance which led people to believe that the business cycle had been abolished and that growth at around 3 per cent plus would go on smoothly and in perpetuity. This irrational exuberance has been reflected in an enormous pile of debt – which will need to be paid back. This can be achieved by less spending and more savings by consumers, and by banks and companies rebuilding their balance sheets. Living standards can also be lowered through devaluation and inflation. Probably all three will have a part to play. It will all take quite a while to work through.

But this process will provide the springboard for the next cycle and for the next bout of economic expansion. Technical progress will go on – indeed, it is accelerating. New technologies will create new markets and push out the supply curve.

As with the boom, it will matter whether monetary policy goes with the grain or whether it makes the downturn worse. Just as very low real interest rates exacerbated the excesses of the boom, so monetary policy could seriously derail the eventual recovery. And then of course there is the environment and the possibility that, as world population rises, and climate change unfolds, there might be a significant shock to the world economy. But there have always been new and special challenges, and so far markets and economies have coped. Recessions have been one of the necessary parts of that process.


Dieter Helm, Professor of Energy Policy, University of Oxford & Fellow in Economics, New College, Oxford

Dieter Helm is an economist, specialising in utilities, infrastructure, regulation and the environment, and concentrates on the energy, water and transport sectors in Britain and Europe.

© D.R. Helm, 2007