May 20, 2001

Snared in a liquidity trap recession

Posted in International Economy ·
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Compaq Presario 251: 750Mhz Duron Processor, 64Mb RAM, 8Mb Nvidia Vanta Graphics card, 20Gb Hard Drive — �999.99

Like the one advertised above, the computer you have in your office or at home has more capacity than most of us will ever need in a lifetime.

It’s a bit like being sold a Ferrari when everyone knows the speed limit is 40mph. The manufacturer probably never envisaged that any of us would use more than a fraction of the computer’s potential. There is now more computer firepower in the average PC today than there was in all the Nasa hardware used to successfully guide and land Apollo 11 on the moon. This phenomenal capacity at such a low price is either a fantastic testament to technical progress during the 1990s or a serious warning about the nature of a US recession in the early years of the 21st century.

Over the past year we have heard most of the “technical miracle” arguments. They tend to go along the following lines: large investment in computers and general technology is making people more productive and, as a result, there is a new paradigm abroad, the world having truly changed. Despite the fall in technology share prices, this may still be half right.

However, there is an equally compelling view which postulates that while technology has changed the world irrevocably, the real change is not so much the potential of huge investment but the problems associated with it. The crux of the issue is that too much investment can cause recessions and too much capacity can result in very long, unexpected downturns. In many ways this investment-led business cycle is more reminiscent of the global economy of the late 19th century and early 20th century than anything we’ve seen since the war.

Since 1945, recessions have tended to be short, shallow and solvable. Periods of expansion led to strong demand exceeding supply. Prices rose. Companies, seeing prices and demand rising, built up inventories in the expectation of selling the stuff later. However, central banks reacted to inflation by increasing interest rates. Demand quickly fell and companies were caught wrong-footed. They stopped producing, slashed prices and laid off workers in an effort to get rid of unwanted stock. The slump in activity is termed a recession. When all the unwanted stock is eventually sold, the recession is over. Traditionally, recessions were signalled by inflation, caused by excessive stocks and triggered by higher interest rates. If we contrast this well signposted path with the unexpected slump in the US today, we have to conclude that something has indeed changed in global economic conditions.

During the week, I had a conversation with a senior policy adviser for one of our more thoughtful political parties. He was perturbed about what signs we should be looking for in order to spot a slowdown in our economy? Fair question. But what happens if there are no amber lights? What happens if the techno-evangelists are right and there is a “new paradigm” that allows recessions to creep up unannounced?

To answer these questions we have to examine the US of the 1990s. The first notable attribute of the US boom has been its length. Since World War II, booms have ranged from 12 months to the current 120 months. The 1990s expansion is the longest on record. Yet, when the downturn came last winter, there was no warning. There were no traditional signs of inflation, nor was the downturn preceded by a period of high interest rates. In contrast, interest rates (adjusted for inflation) have been relatively unchanged since early 1998. The US is on the ropes because investment is collapsing, profits are imploding and share prices cascading.

To understand the sea change in the US modus operandi we have to go back to the mid 1990s when a combination of free trade, deregulation, competition and pliant workers reduced inflationary pressures in the US economy. Without the benefit of the traditional early warning signals, the central bank — rightly — kept interest rates low. These low rates allowed the stock market to soar, further reducing the cost of borrowing. Companies wanting to grow could issue paper in their overvalued stock in order to finance expansion. Such investment increased productivity, reinforcing a false sense of security.

Lenders, believing the hype, extended borrowing and loosened their usual prudential limits. Fuelled by optimism and cheap money, asset prices and investment went through the roof. And, as always in booms, bad investments got financed and, understandably, employees spent like there was no tomorrow. Yet with inflation nowhere to be seen, the US central bank kept its powder dry.

Both personal and corporate debt exploded, savings fell and the US switched to living off a large overdraft called the current account deficit. And, because inflation did not emerge, financial excess verging on delinquency has been the driving force of the so-called “new economy”.

Last year this over-investment and over capacity eventually led to a fall in the return on capital. Companies tightened their belts, as did consumers, and we accelerated into a situation where profit warning after profit warning signalled disaster for over-enthusiastic companies and investors.

The US is now in an over-capacity trap. Due to the huge capacity in your computer, you are hardly likely to buy another one for five years. Therefore, no matter how low the price goes, your demand will not perk up. This is happening across the economy. Companies become locked into a race to the bottom, as they try to offload the unwanted inventories. A vicious cycle emerges where prices are slashed and producers try to out-discount each other. If demand remains subdued, only cost cutting and job losses can save profitability.

In a traditional US recession like 1980/82 or 1989/91, the central bank cuts interest rates aggressively and the economy responds. Normally, when the central bank moves, stocks rise rapidly in expectation of a full recovery. This time, stocks are not really moving. Last Tuesday the Fed cut interest rates and promised more in the pipeline but the markets just shrugged. When there has been too much investment, resulting in too much personal and corporate debt, lowering interest rates will not work. This dilemma is called a “liquidity trap” and, in an indebted economy, cutting interest rates has as little effect as pushing on a string.

Without the prospect of a quick fix, the US might be facing a long recession that will not lift until all the extra capacity generated since 1997 in high-tech, on the net and in telecoms has been fully used up. This may take years. The average recession in typical post-1945 conditions endured for 11 months; between 1854 and 1945 it was 21 months. Arguably, the pre-war experience has more resonance this time around.

Just in case you thought Ireland was free of such concerns, our situation is, if anything, worse than the US. Since 1997, we have been going into debt three times faster than the Americans have and five times faster than the average European. Our savings ratio has fallen faster in the past three years than anywhere else in the world and, unlike the Yanks, we are continuing to borrow heavily. Finally, we are producing high-tech exports in the very sectors that are now saturated by too much capacity. Not a pretty picture.

So the next time you are a computer store and the sales guy is urging you to upgrade for �999.99, hold on to your shekels. Pre-war economic history tells us that by Christmas he’ll be flogging it for �899.99. The conditions in the US indicate that falling prices, depression and sobriety are set to replace inflation, effervescence and exhibitionism — that is until the billions of dollars of excess capacity from the “new economy” investment binge dry up.