October 28, 2001	Sunday	Shaba'an 10, 1422

LONDON, Oct 27: The United States is in the early stages of a recession which could be as deep and intractable as any since the second World War, with serious consequences for the rest of the world. The situation can be remedied, but only if there are large changes in policy, in the US and elsewhere.

A year ago, the general opinion in the US was that the business cycle had been abolished and that the good times were here to stay. There was neither any need nor any place for active fiscal policy, and inflation would be controlled if interest rates were suitably adjusted by an independent central bank. Professor Edmund Phelps of Columbia University pronounced growth to be “structural” and in September 2000 the consensus forecast was that GDP in the US would rise 3.7 per cent between 2000 and 2001.

These euphoric views, based on a supposed “supply side” revolution, ignored the fact that aggregate demand in the US had been driven for many years in an unusual and unsustainable way. The fiscal stance had become so tight that the budget was in structural surplus while net export demand had fallen so much that there was a record balance of payments deficit.

That total demand could nevertheless rise so fast was due to the fact that these negative forces were more than offset by a uniquely large rise in private expenditure relative to income. Net saving by the private sector fell from 5.5 per cent of GDP in 1992 to -6 per cent at the end of last year; this was the extent to which private spending at that time exceeded income.

This excess spending was only possible because there had been a prolonged surge in private borrowing which resulted in ever higher levels of debt relative to income. The whole process was obviously unsustainable and had made the private sector (businesses and households) dangerously vulnerable to negative shocks — a downturn in investment, asset prices, income, employment or profits.

Although nothing comparable had previously happened in the US, similar falls in saving, generated by credit booms, drove rapid expansions in the UK, Scandinavia and Japan just over 10 years ago. In each case there was a reversion of net saving to normal levels — that is, private expenditure fell back below income — and a severe and intractable recession.

It is clear that in the US a similar implosion began in the fourth quarter of 2000. There has been a rise in private net saving caused initially by a fall in investment and stock prices, consequently the economic expansion ground to a halt in the second quarter of 2001, well before the terrorist attacks. A further slowdown, reinforced by the attacks, has almost certainly continued.

The amazing change in rhetoric has not been very edifying. Everyone agrees that the US is now in recession and everyone agrees too, in an astonishing volte-face, that an immediate fiscal stimulus is needed. Goldilocks and “structural growth” have been quietly forgotten.

With regard to the scale and duration of the US recession and the policies which may now be appropriate, three points need to be borne in mind.

First, the recession may be much more severe than most people suppose; for instance the October consensus forecast is that US GDP will rise by 1.2 per cent between 2001 and 2002, implying that recovery from the recession will be in full swing in nine months’ time. But if, as I believe to be possible, private net saving reverts to its historic norm over the next two years, this would remove a gigantic chunk of demand equal to about 7-8 per cent of GDP or 750 billion US dollars, from the circular flow of income.

Such a demand deficiency would swamp all the announced expansionary fiscal measures, which can hardly exceed $1-200 billion (per annum) at the outside. If private saving were to revert to its normal level as fast as it did 11 years ago in the UK, there could be an absolute fall of 2 per cent in GDP between this year and next.

Second, there seems to be a growing consensus in the US that, because there will soon be a spontaneous recovery, any fiscal stimulus should be temporary. However, according to the scenario I am outlining, the unravelling taking place is a reversion to a normal situation from an abnormal one. For this reason, there may be no spontaneous recovery in prospect at all. According to this story, the move of the budget over a period of years into structural surplus was misguided and will have to be permanently reversed.

Third, fiscal and monetary expansion would probably not, by themselves, provide an effective and lasting antidote should there now be a long period of stagnation with rising unemployment because the period starts off with such a huge balance of payments deficit. If growth were rehabilitated by unilateral expansionary measures at home, it seems probable, particularly as growth in the rest of the world is faltering, that the deficit would start growing again, perhaps reaching 6-7 per cent of GDP in a few years.—Dawn\Guardian News Service