Hamish McRae: A mild recession could do America good

So will the new president of the US, whosoever he may be it being "he" looking rather more likely now inherit an economy in recession? The answer is: quite probably... but actually there are other issues facing the US economy that matter even more.

There is no question that the US economy (and our own to some extent) will have slower growth this year, following weakness in the housing market and consequent financial stresses. But whether growth dips below the zero watermark for two quarters, the technical definition of recession, is less important than the longer-term slog that the economy will face over the next five or so years. The task of the next president will be not only to help shepherd the US economy through the downturn but make it a more effective global competitor in the medium term.

The stakes are high. It is more or less inevitable that the US economy will lose size relative to the world economy over the next couple of decades, as it has over the past one. That is simply a function of the faster growth of China, India and the other emerging economies. Europe is losing global "market share" even more swiftly. We should not exaggerate the ability of any government to make a radical difference to a country's economic performance but a wise president can in some measure help the US maintain global economic leadership, while a duff one can hasten decline.

But first the recession, if indeed there is to be one, because the present bout of weakness in the US is in large measure the result of poor economic management. The US economy now is in trouble because of a debt bubble. Demand was puffed up by the lax fiscal policy of the two Bush administrations coupled with excessively low interest rates from the Federal Reserve.

The US went on a spending and borrowing binge an even bigger one than we did at both a public and a private level. Overall demand was inflated by tax cuts with the result that the budget deficit rose to more than 4 per cent of GDP and the current account balance of payments deficit reached 7 per cent of GDP. Both deficits are now narrowing but only slowly.

Meanwhile, as we can now see, private individuals were encouraged by cheap loans to fund an unsustainable housing boom. Home prices in the US have now been falling for the best part of a year as opposed to about three months in the UK, and it is that decline that may have triggered recession. The economists are split pretty evenly as to whether that is happening.

My instinct, for what it is worth, is that if there is a recession it will be a shallow one but very slow growth will continue for quite a while. Plotted on a graph, US economic growth will look more like a U than a V. That is a minority view, for most economists do expect a recovery in 2009. But everyone agrees that this year will be a very difficult one.

The next president cannot of course do anything about this. The world experiences global downturns about every 10 years for reasons that I don't think anyone fully understands and the task facing all national governments is how to help their own economies to come through these downturns with as little damage as possible.

By the time the next president takes office the scale of the downturn will be much more evident but what will be happening will have been shaped by policies of four or more years ago. He can however shape the recovery and by that I don't just mean the rate of economic growth. I mean its quality and durability. There may be a long lag between an economic policy being put in place and it affecting actual performance but economic policies do matter.

The big point here is that if the US is to retain economic leadership it cannot carry on borrowing so much of the savings of the rest of the world. At the moment Asian savings are funding US consumption. The world's poor, or at least its relatively poor, are paying for the lifestyles of the world's rich. It is an implicit bargain that the US has struck, most notably with China, and it is an inherently unstable one.

China lends the cash for Americans to fill their homes with its tat. Both sides are responsible. China's resistance to a faster revaluation of its currency means that it piles up dollars in its national reserves and its new sovereign wealth funds. And as noted above, lax fiscal and monetary policies in the US have encouraged the American consumer to hit the shopping malls.

So what will happen? Well, a recession will help a bit. That is not the sort of thing you are supposed to say how can a set of economic conditions that push people out of jobs, cut output and generate human distress, actually be good?

The answer is that you need these periods of difficulty to stop the various parts of society, including companies, banks, individuals and government agencies, from behaving in ways that are destructive. It cannot be sensible for people to borrow six or more times their income to buy a home. But if you have a long period of rising house prices and rising incomes both borrowers and lenders are lulled into thinking this normal. Put bluntly, a recession forces prudent behaviour in a way that no regulation or exhortation can do.

So a US recession or even a sharp slowdown, coupled with a lower dollar, will narrow the US current account deficit; in fact that is already happening. The huge losses by the US banks and other financial institutions on housing debt are correcting lending policies on mortgages. Slower growth of consumption should allow people to clear some of their credit card debt. The squeeze on real incomes from higher oil prices will encourage Americans to switch to more fuel-efficient cars. And so on.

But just to rely on tougher times to rebalance the US economy is to miss a huge opportunity. The next president needs to learn from the mistakes of the past one, in economics as in other aspects of policy. The next economic expansion should be built on sounder foundations than the last one.

That is not rocket science: it just means trying to set a reasonably sound fiscal policy, trying to encourage more responsible monetary policies though this is the role of the Fed, not the administration. It means the sensible use of regulation, rather than using regulation to favour special interest groups. It means encouraging economic efficiency rather than resorting to protectionism, always a danger.

The US economy is inherently tremendously competitive. It will remain the world's largest for another 20 years, maybe longer. It should not allow itself to be so dependent on foreign loans to keep it going. That is just not sensible and a new president should recognise that. And lest we become too complacent, it should be said that some of the same trends have been developing here.