Economic View: Budget? What Budget? America is reeling

The economic focus last week switched back to the global markets and in particular the United States. Yes, some of you may recall that we had a thing called a Budget that the new chap read out in Parliament, but as he himself acknowledged, what really matters is what happens to the world economy.

The alarm bells were ringing loud but not very clear. Start with America. On Tuesday the US Federal Reserve pushed $200bn (£100bn) into the markets, taking mortgage-backed securities as collateral. Other central banks around the world, including the Bank of England and European Central Bank, joined in on a smaller scale. The share markets recovered for a bit, then fell back. A big hedge fund collapsed. Then on Friday the US had a Northern Rock moment, when the New York Federal Reserve in effect underwrote a rescue by JP Morgan Chase of Bear Stearns, the second-rank US investment bank that has been under pressure for some weeks. The markets threw yet another wobbly.

This is all US sub-prime mortgage related. In other words, the chaos in American financial markets is further fall-out from a known explosion that took place some months ago. It is toxic fallout and there is more to come down.

The new, if less dramatic, news last week was that the US economy is now almost certainly in recession. We won't know for another month what has actually happened during this first quarter, and the technical definition of recession is two quarters of negative growth, not one, but it does look as though the US economy is currently contracting. There were some bad consumer demand figures and since consumption is 70 per cent of demand, if the spenders stop spending then recession becomes inevitable.

But what might the profile of the US economy be in the next few quarters? The bar chart, from Capital Economics, shows one such estimate: two quarters of negative growth, then a slight recovery in the third quarter, then a flat final quarter before things pick up in 2009. Overall growth for this calendar year will work out at 0.5 per cent, followed by 2 per cent next. Other forecasters are more optimistic about this year but less so about next. For example, ING Bank has just come out with 1.1 per cent this year and 1.6 per cent in 2009 respectively. Goldman Sachs has 0.9 and 1 per cent.

No one can plot the path of a recession in advance, of course. It is just about plausible that the economy could contract for a quarter, perk up a bit, go down again, then pick up so that technically this is not a recession at all. But in a way the exact profile does not matter too much. The Federal Reserve will drive down interest rates in an effort to pump things up and that has the direct effect of weakening the dollar and the indirect effect of undermining faith in the US as a place to invest.

One classic measure of global financial fear is the gold price. Rationally there is no reason for people to invest in gold, and the fact that on Friday it breached the $1,000-an-ounce mark is partly a mechanical result of the falling dollar. But while the gold price does not matter in itself, it is a useful symbolic indicator of distrust in financial instruments.

The oil price, by contrast, does matter, as those of us who filled up our cars last week will be all too aware. It is now clearly above the $100-a-barrel point, and while in real terms (ie, adjusted for inflation) this is lower than the $80 peak in the early 1980s, it is high enough to cause disruption in other commodity markets. It pushes up the price of everything: food as well as consumer goods; final products as well as capital goods. We have an inflationary problem but so too does Europe, so too does the US, so too does China and the Middle East. Inevitably, the high oil price will slow the world economy and redistribute wealth from consuming countries to producing ones. That redistribution, the shuffling around of cash, itself puts pressure on financial markets for they have to recycle the stuff.

None of this is without precedent. Economic cycles and financial crashes have happened before. Our Northern Rock is less serious than the fringe banking crisis in the 1970s. Even the Bear Sterns debacle is smaller than the collapse and subsequent rescue of Continental Illinois in 1984. The reaction in the world's equity markets is, so far at least, nothing like as bad as the three-year bear market from the beginning of 2000 to the spring of 2003. When bankers say "this is unprecedented", what they mean is: "We've screwed up and we are trying to blame the markets for our own greed and stupidity."

The question, really , is not: is this cycle unusual by historical standards? It isn't. The question is: what is the most likely path it will take?

For the US, the broad picture of a difficult time this year and a disappointingly slow recovery next seems the most sensible outlook. Financial crises always have seminal moments – a catastrophe that signals a turning point. There may well be further market ructions and a larger enterprise than Bear Stearns may end up needing to be rescued. If there were a run on a really big bank, and a rescue thereof, then that might be that point.

Alternatively, the crisis might be a true collapse of the dollar, with co-ordinated action by the world's central banks to rescue it. To make that effective, there would have to be co-operation from the Bank of China and I would like to see the central banks of India and Russia involved too. That would be humiliating for the US and things have to get a lot worse for such a deal to be done. The trick under these circumstances is to get the central banks to act in concert to steady the currency just at the moment when the markets are ready to turn. Meanwhile, a botched attempt at a rescue would be more damaging than no rescue at all.

There are two big points here. One is that a US recession will have some knock-on effects for the rest of us. The other is that it is likely to be some months before calm returns. From a UK point of view, there will certainly be a slowdown, but I still believe that this year will see reasonable growth. It is next year I am more worried about – but that is a story for another day.

Do we vote with our hearts? Are religious people happier? Just ask an economist

Want to know whether people vote with their wallets and purses or with their heart? Or whether large pay differentials in firms make workers contented or envious? Or whether religious people are happier than atheists?

Just ask an economist, for these are the subjects of three of the papers being presented at the Royal Economic Society's annual conference at Warwick University this week. The answer to the first, drawn from a huge survey of French voters, is clearly that money matters more than ideology. I think you might expect that, but you might be surprised by the answer to the second one. It seems that when bosses are well paid, employees are happier, apparently because they think they may be better paid in the future. As for religion, not only are religious people happier – the more often they worship, the happier they get. Um.

There are many more papers, giving insights on a host of social issues, including the "glass ceiling" faced by women scientists, whether to settle a case out of court, getting more disabled people to work and many more.

What I find fascinating is to see the range of research that economists are now doing and the way in which such research could be used to craft better policies. For obvious reasons, much of the comment on economic matters focuses on the big macro-economic issues of employment, growth, taxation and so on. But the detail of the micro-economic side of the discipline is in many ways more interesting. So all credit to the Royal Economic Society (I should disclose I am on its council) for putting the goods in the shop window.

Finally, some information that may have been more practical use ahead of last week's Cheltenham Festival: if you want the best odds on the favourite, place your cash with a bookie; but if you want to back an outsider, bet on the Tote. Economic research says so, so it must be true.