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Right now, economists across the world are all asking the same question: Will the US hit recession, or can it be avoided?
Some say that this is a problem that has an easy fix. All that is required for the US to avoid recession is for the Fed to slash interest rates and print lots of money. There’s no doubt that if Fed chairman Ben Bernanke came out in support of those policies the markets would soar. After all, Ben drew praise indeed from analysts when the Fed lowered rates by half a per cent in September – with the men and women of Wall Street sayings things like “the Fed gets it,” and then drawing big sighs of relief.
What is often quite attractive about America is its degree of optimism. This is a country that has a “can do” attitude permeating business. Maybe the British tendency to look at the world over the rim of a half empty glass, has held back enterpreneurism and business investment in the UK, perhaps leading to the British pre-occupation with property – which is seen as safe.
Even so, sometimes an attractive trait can become too much, and frankly, of late it feels as if the single biggest export from the US has been exuberance of a truly irrational nature. We have commented on it many times as the markets go out and buy at the slightest excuse.
For example, back in early October, when the Dow inexplicably hit an all-time high, we said that markets were celebrating because things were so bad in the US that it was considered inevitable the Fed would announce further interest rate cuts.
Well, of late, even irrational optimism has taken a hit, with a growing chorus of voices predicting US recession in the months ahead. On Friday, for example, British economics consultancy Capital Economics said it was predicting zero US growth for the last quarter of this year. It also predicts, by the way, a surge in US inflation – perhaps with consumer price inflation hitting 5 per cent in December on the back of the high price of oil – meaning stagflation: that’s low growth and inflation at the same time.
But then recently, an economist from American Enterprise Institute for Public Policy Research, John H. Makin, has at first glance lived up to the finest trait of America, its optimism, by saying that actually recession is exactly what the US needs.
But Mr Makin’s analysis is not born of optimism. Rather he sees recession as inevitable. “Every housing sector downturn since World War II has led to recession," says the economist. And more damning: “The bottom line on the housing and mortgage crisis has not changed since housing prices started to soften in 2006, and have since started to fall nationally on a year-over-year basis for the first time since the Great Depression.”
Mr Makin adds, “Given that this housing downturn is more intense than most and has involved greater compromise of the balance sheets of major banks, there is no reason to suppose that a US recession in 2008 is not at hand. The only way to avoid it would be a massive easing stimulus by the Fed that resulted in a reversal of the drop in house prices – a virtually impossible undertaking – which would surely entail the return of the serious inflation that the Fed is pledged to avoid."
Mr Makin says the current economic crisis has its roots in excessive risk taking. "We have discovered," he says, "that widespread underpricing of risk has resulted in a housing bubble, the unwinding of which will cause a US recession. In the name of avoiding a recession, should the financial decision-makers involved in creating the bubble be protected?
"If decision-makers conclude that when excessive risks are undertaken, either the Fed or the Treasury will step in if necessary to keep the economy on an even keel, then such intervention will lead to too much risk-taking. Excessive risk-taking will result in more volatile growth and inflation, which, as we have learned over the past twenty-five years, is to be avoided if long-run stable growth of output and productivity is to be encouraged."
Mr Makin draws on further ammunition to support his argument, by then turning his gaze many thousands of miles to the east, to the economy of the rising sun. "The route to sustainable growth is not continued bail outs for bankers and financial innovators who have contrived ways to undervalue risk. Japanese bank regulators demonstrated that, by allowing banks to hide toxic waste on their balance sheets during Japan's 'lost decade' of the 1990s," he says.
The big problem according to this most bearish of Americans is government intervention. "Economists are quick to argue that government intervention on a micro basis can distort resource allocation. So too can excessive government intervention on a macro basis," he said.
I am inclined to agree with Mr Makin. People who are pro markets are invariably anti subsidies. Subsidies reward inefficient producers and penalise the consumer. And yet a bail out of the financial markets would in effect be a subsidy. Bankers and investors are quick to lambaste government intervention when it is applied to companies operating outside of the financial sector. And yet, when it's the banks that need handouts and subsidies, all of a sudden central banks who oblige are seen as prudent and responsible.
That’s why we have been impressed by the handling of the financial crisis by Mervyn King, and why right now, the cheek of bankers and analysts calling for more help from central banks really is beyond the pale.
I think you have this one dangerously wrong. A central bank's prime responsibility (rarely stated, because it's so obvious) is to maintain liquidity in the banking system, otherwise the whole economy grinds to a halt. That's where King got it wrong, and allowed a bad situation to worsen. Globalisation of financial instrument trading, legal structures and demand for yield created an environment that allowed banks to distribute assets. The investment banks got it wrong, and had to take a hit, most of which was covered by third quarter earnings - so where's the problem? Risks were taken, high prices paid (jobs/reputation) - that's the way it goes sometimes. The banking industry does not want subsidies or handouts - what it (and the entire global system) needs is central banks to fulfil their roles as liquidity providers. The real danger is that ongoing prevarication and uncertainty will lead to higher costs for all market economies, resulting in a global downturn which could then feed on itself as many interlocking positions unwind, causing a worldwide economic meltdown that might take years to recover from. That is why I think it is a very dangerous attitude for commentators to perpetrate the 'handouts and subsidies' analysis.
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