Sunday, October 26, 2008
Small recessions hurt, but big ones are scary
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


What's a recession like? I pose this not just as a service to younger readers but to set in context a week of confessions from Mervyn King and Gordon Brown, both of whom used the R-word ahead of Friday's figures showing that the recession has begun.

A consensus is emerging on the broad shape of that recession. Both the National Institute of Economic and Social Research (NIESR) and the Ernst & Young Item Club think that after growth of 1% this year, the economy will contract by about 1% next, before growing by a modest 1% in 2010.

Put like that, a recession does not sound so bad, more like a pause than anything more serious, so how bad can it be? And how would a recession like that compare with what Britain has suffered in the past?

We do not know if the emerging consensus will be right; to an extent forecasters have been racing to keep up with a deteriorating economy and many are busy revising down their forecasts this weekend. But suppose we do get a +1%, -1%, +1% pattern. On the face of it there will just be a temporary loss of output, spending and incomes in 2009, soon made up in 2010. How bad can that be?

The reason modest numbers are uncomfortable is that you have to compare them with what would have happened in recession's absence. Normal, "trend" growth for the economy is 2.75% a year. In the three years 2008 to 2010, GDP would have been expected to grow by a cumulative 8.5%. Instead it may grow by 1%.

By 2010 there will be a GDP shortfall, relative to what should have happened, of 7.5%, 107 billion at today's prices. That's a lot of output, income, spending and jobs, and it is why even mild recessions are painful.

How would the expected pattern compare with past recessions? It is closer than you might think to the last recession. Then, the economy grew 0.8% in 1990, shrank by 1.4% in 1991 and grew 0.2% in 1992. Many will recall there was huge pain associated with these innocuous numbers. The previous big recessions of the post-war era, 1980-81 and 1974-75, each saw two consecutive years of GDP falls.

The best way of looking at recessions, however, is the peak-to-trough fall in GDP. Where did the economy start to fall, and how much did it fall? Again, though it did not seem so then, the recession of the early 1990s was mild, with a peak-to-trough GDP fall of 2.5%, less than half of that in 1980-81, a huge 6.1%, and lower than 1974-75, 3.5%.

This time, says NIESR, the peak-to-trough fall will be 1.2%. As I say, we will notice that a lot, but it will be modest compared with past recessions.

Will it be so mild? Geoff Dicks of Royal Bank of Scotland Financial Markets, asks "Will it be worse than last time?" and says: "Conventional analysis says no. We did not have the boom of the late-1980s; inflation is 5% and falling, not heading to 10%; interest rates are 4.5% not 15%; we have not locked into the ERM [exchange-rate mechanism] at an uncompetitive rate; fiscal policy will become more expansionary."

The unknown, hard for economists to model and forecast, is the impact of banking and the lending squeeze that is part of the banks' deleveraging.

Even with that huge uncertainty, there are positives. The first quarter of recession sets the tone. The first quarterly decline in 1990-92 was its "falling off a cliff" moment, when GDP fell by 1.2%, half its entire drop during the recession. There were similar big declines at the onset of the two earlier recessions. The third-quarter drop in GDP revealed on Friday was larger than expected, but at 0.5% was not as bad as in 1990.

Second, the fact that policymakers are using the R-word is encouraging. Margaret Thatcher left office late in 1990 denying the economy was in recession. Early recognition is a prerequisite for action.

Third, every policy instrument is being thrown at it, including rate cuts, devaluation and, where possible, fiscal policy. It may not be enough to offset banking's dead hand but should limit the decline.

What about King, now he has put his name to the first recession in the Bank's independence era? I get plenty of e-mails blaming me personally for the economy's woes so I cannot imagine what his inbox is like. The Daily Telegraph has called for his immediate resignation and a guest piece in The Times, our sister paper, marred by some howlers, called for rate decisions to be handed back to the politicians. Not, I think, a good idea.

King's Leeds speech is worth reading it's on the Bank's website. You don't often hear a Bank governor saying the banking system came within an inch of meltdown. If I have a criticism it is that he sometimes comes over as commentator rather than participant. The Bank, whose part in the banking rescue package was pivotal, hugely influences events. On interest rates, most members of the MPC, including King, were slow to spot the recessionary danger.

The NIESR's latest review, devoted to "The Great Crash of 2008", is also worth reading. We know the banks will change when the dust settles but how will the Bank change? Sushil Wadhwani, a former MPC member, argues in the review that in future the Bank should be prepared to "lean against the wind" when it comes to big rises in asset prices, such as houses.

The Alan Greenspan model of central banking, essentially adopted by the Bank, established the principle that if booms or bubbles in asset prices occur and then burst, there was no need to worry as long as it was possible to mop up easily afterwards.

That was Greenspan's view of the stock market and the Bank's view of Britain's housing market. It seemed reasonable. The economy and housing were sensitive to small changes in interest rates, allowing the Bank to manage any decline. The credit crunch has changed that, seriously reducing the Bank's ability to achieve an orderly unwinding of the house-price boom. That is one important lesson of these extraordinary times.

PS: In grim times we have to look to our brains to get us out of the mess. Fortunately, there is still good news out there. Nesta, the National Endowment for Science, Technology and the Arts, invests in early-stage, innovative companies. If the flow of new investments were drying up, you would be worried about the longer-term outlook.

But Jonathan Kestenbaum, Nesta chief executive, is upbeat. His investments include: 3m into OsSpray, which uses bioactive glass for dental cleaning procedures; 2m into MMIC Solutions, which works with integrated circuits; 7.2m into Starbridge Systems and its new injection-free method of giving diabetics insulin; and 12m into Tideway Systems, which does application dependency mapping.

Nesta, which sells on investments once past the early stage, reminds us there is more to the economy than the City (3%-4% of GDP) and the wider financial services sector, including the City (8%-9% of GDP). Not that the City has shut up shop, of course.

We need knowledge-intensive businesses. Last week Foresight, the government think tank, published a report underlining the importance of "developing our brains from cradle to grave". Putting brains to work on new business ideas and applications has never been more important.

From The Sunday Times, October 26 2008