Sunday, February 15, 2009
In deep - what will bring us back to life?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Economics has not covered itself with glory in predicting the situation we find ourselves in. The bankers' models did not work and neither did those of economists.

Economics also struggles when it comes to defining its own language. So let me start this week with an extended throat-clearing exercise, defining a few terms.

Then I'll come on to explaining some of the "unconventional" things the Bank of England is about to embark on to try to resuscitate the patient.

Everybody knows what a recession is, do they not? Last month's publication of figures showing a 1.5% drop in gross domestic product in the fourth quarter its second successive fall was accompanied by any number of headlines and broadcasts showing Britain to be "officially" in recession.

Except there is no generally accepted definition of recession. The National Bureau of Economic Research in America defines it as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales".

While this has advantages over the two-quarter definition, it is rather imprecise, so some economists focus on unemployment, and a rise of 1.5 to 2 percentage points in the jobless rate over 12 months. But that would mean Britain is not yet in recession on both measures unemployment has yet to increase that much and might be considered too backward-looking.

That leaves us with, in my view, the most robust recession definition, used by the late Christopher Dow in a book called, appropriately, Major Recessions. He pointed out that you could have a "growth recession", a period of very weak growth within a rising trend. Even this can hurt. As I have pointed out before, it is the "lost" growth you normally expect that makes recessions so painful.

For him, however, a recession worthy of the name was one featuring a "clear absolute fall in GDP between one calendar year and the next", usually but not always followed by a second fall. Big recessions had the characteristic of a "sharp descent" followed by a "protracted recovery".

So we are in a big recession or, as Mervyn King described it last week, "deep". More on that in a moment. But what about the word that dare not speak its name depression except when let slip by Gordon Brown or implied by his former chief economic adviser, Ed Balls?

Saul Eslake, ANZ Bank's chief economist, had a good go at this in a recent paper, entitled What is the difference between a recession and a depression? Economists think they know, because they think of the 1930s, so a peak-to-trough GDP fall of 10% or more, or a decline lasting three to four years, or both, fit the bill.

In that respect, the Great Depression of the 1930s was not one as far as Britain was concerned. GDP fell by just over 5% and the decline lasted only two years. The period 1919-21, when there was a fall of nearly 25%, was much worse.

Eslake, however, thinks the key distinction between recessions and depressions is their cause. Brown always reminds us the causes of this downturn are not the usual ones. Maybe he knew more than he let on using the D word.

"The distinction hangs on the causes and other characteristics of the downturn," Eslake writes. "In particular, a recession is nearly always the result of a period of tight monetary policy, while a depression entails a significant and protracted asset-price cycle; it involves a contraction in credit or debt (thus potentially rendering monetary policy impotent); and it is characterised by a decline in the general price level as well as in economic activity."

You can have mild depressions as well as big ones, he notes. But if another common theme is that policymakers are required to do something they would not do in a normal recession, maybe we should not shy away from the D word, though the fear of reawakening the ghosts of the 1930s is understandable.

What about that other D word, deflation, a fall in the general price level? There is good and bad deflation. The sharp fall in commodity and energy prices boosting real income growth is good deflation, not least because it is temporary. The Bank's view is that there will be good deflation this year, as those big price rises unwind, but "the likelihood of a persistent period of deflation in the UK is judged to be small".

It is partly to head off that risk that the Bank, having done quite a lot of unconventional things already, including swamping the banking system with liquidity and cutting interest rates to 1%, is prepared to walk even further on the wild side.

The message of its inflation report last week was that at its meeting in early March the Bank's monetary policy committee will decide whether to embark on so-called quantitative easing, boosting the "broad" money supply by buying in gilts, corporate bonds and other assets from the private sector and paying for it by expanding the Bank's balance sheet.

Quantitative easing should be distinguished from credit easing or its close relative, "qualitative" easing. The 50 billion asset-purchase facility the Bank has started comes under these headings. It involves the purchase by the Bank of illiquid assets from banks, swapping them for liquid assets they can use as the basis for increasing lending. The Bank's balance sheet does not expand, though its composition changes, and there is no effect on money supply.

Some economists think the Bank should stick at that and not go down the quantitative-easing route. DeAnne Julius, former MPC member, now an adviser to Fathom, which last week launched its monetary-policy forum, urges caution.

Quantitative easing could be ineffective, as most economists think was the case in Japan in the 2001-6 period. It could end up being inflationary, hard as it is at present to see the return of inflation. Done properly, however, it could make a difference and because of that it is worth a try.

In the end, though, where we head now, and whether either of the D words becomes appropriate, depends more on the conventional than the unconventional.

A useful table in the Bank's inflation report looks at the combined economic stimulus over the 12 months to the end of last year and compares it with the run-up to previous recessions. It includes a 3.5 point cut in Bank rate, a 22% fall in sterling, a 40% drop in oil prices and a 2% easing in the government's fiscal stance.

In the run-up to the three previous big recessions, interest rates, sterling and oil had normally been rising and fiscal policy tightening. That confirms the causes of this downturn are different. But it also tells us that if all this, combined with unconventional measures, does not work, probably nothing will.

Though lags between policy changes and their impact can be long and variable, "whatever it takes" will eventually make a big difference.

PS Sorting through some stuff I came across my press badge for the Brussels summit in 1998 that launched the euro project in a fanfare. The meeting, recalled by David Marsh in his excellent new book, The Euro: The Politics of the New Global Currency (Yale University Press), was marred by a Franco-German row over who should be the European Central Bank's first president.

Tony Blair, chairing the meeting, was ill-prepared for the disagreement and the euro got off to a poor start, though its second five years were better. Things are now very tough, though, hence Friday's sharp 1.5% drop in euroland GDP, which included a 2.1% plunge in Germany.

I'll return to the book another time, but anybody hoping the current crisis will speed UK entry will not get much succour. After talking to many people, Marsh finds the political gulf is widening and said the UK will stay outside until at least 2025. Who knows where we will be then?

From The Sunday Times. February 15 2009