America's long and tricky road:

Despite last week's encouraging figures for first quarter gross domestic product, the Federal Reserve still fears a recession. Only that can explain the speed with which it has cut interest rates. It is right to do so.

With the collapse of the asset price bubble, the US private sector is likely to find its record financial deficit of 7 percent of national output last year unsustainable. But how steep and how lengthy might the subsequent declines in US output and stock markets be? Some observers including Martin Wolf (in "After the Crash", Foreign Policy, September/October 2000) have drawn alarming comparisons with post-bubble recessions in the UK, most Scandinavian countries and Japan, in the late 1980s and early 1990s. But since the American economy differs in important ways, it is important to examine post-war US history. This I have done with a colleague.(*) The sad conclusion is that the pessimists are probably right.

Using a range of forecasting models estimated over the period 1955-2000, we find that annual growth in US gross domestic product should be between plus 0.1 per cent and minus 2.2 per cent this year, with a probability of 95 percent. That would be the sharpest reversal since 1974. Thus, a recession in 2001 remains almost certain. This is worse than the markets expect, even now. There are also good reasons not to forecast a big recovery in 2002.

We can isolate a dozen or so factors operating on US growth. Almost all imply a contraction of activity. Consider just a few of them.

In 1999 and 2000, the US economy was operating well above capacity: this can be seen in above trend GDP, the ballooning trade deficit and the rise in inflation. All three factors imply a slowdown in 2001.

In addition, the costs of finance and the level of the stock market will adversely affect business investment and consumer spending for some time. There is a considerable lag between a rise in interest rates and a decline in economic activity. So the rise in 2000, compared with 1999, still has a negative impact. The two percentage point cut in the federal funds rate since January barely even compensates for the falls in the stock market.

Another negative element is credit contraction. This multiplies the impact of declining asset prices. Most borrowing from banks and other financial institutions is backed by collateral, while loan conditions (such as interest rates and the size and duration of loans) depend on the net worth of companies. With the asset price falls and the greater uncertainty, credit availability diminishes and the effective cost of borrowing rises.

A measure of credit conditions derived from the Fed's quarterly Survey of Senior Loan Officers for the eighty largest banks lending to commercial and industrial companies in the US turns out to be a powerful predictor of economic activity.(**) The loan officers reported a tightening of credit conditions throughout 2000. The January 2001 figures imply further tightening.

There is also continuing bad news from high energy prices. In addition, the high value of the dollar against other currencies must further depress US growth.

Against this, one important positive factor is that government debt has been falling relative to national income. Since the early 1990's, when the fiscal deficit came under control, the private sector has taken low deficits and debt as signals that taxes would soon fall or government expenditure rise. The Bush administration's tax cuts accord with this - and are likely to stimulate spending accordingly.

A recession remains probable. How long is it likely to last? Unfortunately, the drag on the US economy from recent trade deficits will not peak until 2002. If the S&P 500 index for 2001 were 25 per cent lower on average than last year, this would further reduce growth by one percentage point in 2002. Finally, the alarming reading from January's loan standards survey suggests that for the year as a whole, credit conditions may well be worse even than last year.

Fortunately, the US economy is far more responsive to lower interest rates than is Japan. So a lengthy Japanese-style recession can be ruled out. Moreover, the US economy is not constrained by foreign debt and the banking system is not heavily implicated in the asset-price bubble.

Another reason for a rebound is suggested by the unexpectedly strong GDP performance in the first quarter. This is linked to the sharp drop in imports, particularly of information technology equipment. The US may be exporting more of the recessionary impulse of weak investment than expected. But since the lifespan of high-technology capital is short, replacement investment could start to pick up already in 2002. That could make the downturn shorter than in historic investment cycles.

Yet policymakers will still find it difficult to restore rapid growth very quickly.

If there were a US recession of this scale, the impact on the global economy would be severe. The fragile state of Japan and other Asian economies will aggravate the downturn. Unfortunately, markets have little confidence that the European Central Bank will come to the rescue, rightly so.

First, its target is a ceiling on inflation of inflation, rather than a symmetrical objective. This imparts a deflationary bias to its policies. Second, its briefings suggest that it takes a short-term or even a backward-looking view of its target, which stops it from cutting rates pre-emptively. Finally, it appears to be using outdated theory, which overstates the effect of interest rates on the exchange rate. Currency movements are driven at least as much by expectations about growth.

In time, the ECB's claims of immunity of the Eurozone from the global downturn will prove to be illusory. By then, alas, the world economy will have experienced an unnecessary further notch in what already looks likely to be a painful contraction.

(*) 'Credit, the Stock Market and Oil:Forecasting U.S. GDP' by John Muellbauer and Luca Nunziata.

(**) see www.federalreserve.gov/boarddocs/snloansurvey
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