[A-List] Global economy: state to save capital (again)

["Michael Keaney" <michael.keaney@xxxxxx>]

Stephen King: Corporate ships are still sinking: let's man the fiscal
lifeboats
If the consumer engines for a recovery have blown a gasket, are rate cuts
likely to be of much benefit?
The Independent, 04 November 2002

Last week's Halloween proved suitably ghoulish for the world economy. The
recovery that seemed to be falling into place earlier in the year now
appears to be stalling, if not going into complete reverse.

Even before last week, we knew that capital spending was facing renewed
difficulties on the back of weak US durable goods orders for September. Over
the last few days, however, it really has been a case of tricks at the
expense of treats. In the United States, manufacturing surveys are
suggesting that companies are starting to fret again, unsure about their
profitability and unwilling to invest (see left-hand chart). For Europe, the
various purchasing managers' surveys were not quite so bad as feared but
still suggest that manufacturers are having a tough time. The US saw
further - albeit modest - job losses. Not a disaster, admittedly, but
certainly not consistent with a decent economic recovery. The mother of all
nasty releases, however, was the drop in US consumer confidence (see
right-hand chart).

October's fall in consumer confidence may, of course, not be terribly
relevant over the medium term. The series does tend to fluctuate from one
month to the next in a fairly volatile fashion. And it may have been the
case that, during October, the sniper attacks made consumers unusually
nervous. Somehow, however, these excuses seem a little bit lame. The decline
in confidence was one of the biggest on record. The level of confidence is
now lower than was the case post-11 September. And the details of the
release reveal that consumers are becoming more nervous about their own
incomes - in other words, they're worried about the threat of pay cuts or,
even worse, job losses.

Should we be concerned? The answer, most definitely, is "yes". The fall in
consumer confidence comes almost two years after the first in a series of
aggressive rate cuts from the Federal Reserve Board. The level of consumer
confidence is now consistent with consumer spending growth - adjusted for
inflation - of no more than 1 or 2 per cent per year. With that kind of
growth rate, the US consumer will no longer be in a position to bail out the
broader economy. Put another way, the central bank gamble designed to keep
consumer spending going until corporate activity picked up is in danger of
failing. Companies are in trouble. And consumers are in danger of following
suit.

This was not supposed to happen. That it is suggests that monetary policy is
not working very well. Think for a second about what central banks had hoped
to achieve. They had quite rightly recognised that companies were in
trouble. They had decided to offset this corporate problem by persuading
consumers to take on more debt. They did this by cutting interest rates. In
response, household debt levels raced upwards to the point at which, in the
US, interest payments on these outstanding debts - expressed as a share of
household income - reached an all-time high, notwithstanding the very low
cost of borrowing.

There comes a point, however, when enough is enough. Although economists are
hopeless at spotting when that point is reached, it is nevertheless the case
that consumers cannot keep building up their debt levels from one year to
the next unless they feel secure about two things. The first is simply that
interest rates should not go back up again which, for the time being, looks
like a very good bet indeed. The second, which may now be proving a lot more
problematic, is that consumers have to feel sure that their future incomes
will grow at a rate that is consistent with the repayment of the capital
associated with any debt. Central banks have delivered the first but may be
beginning to have problems with the second. Whether you look at the weakness
of US car sales over the last few weeks or the wobbles beginning to come
through at the top end of the London housing market, it's beginning to look
as though interest-rate cuts alone may no longer be enough to keep consumers
spending.

To explain what's going wrong, it's worth going back to the second half of
the 1990s. Back then, when companies were investing like crazy on the back
of highly optimistic assumptions about future profitability, the seeds of
the current mess were sown. Companies accumulated too much capital. The
excess capacity - together with greater global competition - drove profits
down to levels that left companies both with excessive levels of debt and
with pension funds that began to show rather too many holes below the
waterline.

The Fed and the Bank of England sent a flotilla of consumer lifeboats out to
save this sinking corporate ship. Slowly, slowly, the lifeboats began to
drag the crippled ship back to shore. But the closer they got, the more
difficult the task; quite simply, the corporate ship took on more and more
water, making the challenge for the consumer flotilla ever more difficult.

The central banks gave consumers more fuel and the consumers' debt engines
worked even harder. But, at the end of the day, they may simply not have
been powerful enough. Have we now reached the point where the consumer
flotilla is now being pulled underwater by the very ship that consumers were
supposed to save?

It's reasonable to say that the central banks have, themselves, not yet
given up all hope. There's now a very good chance that the Fed will cut
interest rates again this week, maybe by as much as 0.5 per cent, taking the
key Fed funds rate down to just 1.25 per cent. Whether others will follow
suit is a rather tricky call. For the European Central Bank, political
pressure calling for a rate cut might, for the time being, be met by a stony
silence. And, as for the Bank of England, we know there are three members of
the Monetary Policy Committee who are keen on lower rates but, as for the
rest, there are doubtless still a few worries about the strength of the
housing market. Whatever the outcome, it certainly is a very close call.

But if the consumer engines have blown a gasket, are rate cuts likely to be
of much benefit? After all, we have had loads of rate reductions in the US
already yet here we are still worrying about whether the cuts seen so far
are really doing the trick. The point is this: companies are still in
trouble and shareholders and bondholders are demanding that something should
be done. For companies, there are limited options: they can cut back on
capital spending again or alternatively they can cut back on labour costs.
The implication appears to be that companies will be trying harder and
harder to pass the burden of adjustment on to their workers and, more
generally, on to consumers.

I've argued before that, under these circumstances, it might be better to
think about alternative ways of patching up the sinking corporate ship. If
companies have too much debt or not enough profit, it may be time for some
more radical repairs. At the beginning of the 1990s, there were plenty of
leaky corporate ships. In the US, the problem was solved by using taxpayers'
money to bail out the savings and loans companies. In Sweden, taxpayers'
money was used to nationalise the banks, thereby reducing the risk of
persistent financial distress. In Japan, nothing was done: the consequences
are now all too obvious. Perhaps now is the time to man the bailout lifeboat
again, targeting fiscal funds towards an orderly rescue of corporate balance
sheets.

Stephen King is managing director of economics at HSBC.