Hamish McRae: Recessions serve a useful purpose

The game has changed. Every day that passes brings more evidence of a rapid slowdown in the world economy. To meet that there will, and should be, a strong policy response not just from the main developed world economies but from the emerging markets too. So there will be tax cuts here and elsewhere, and there will be further cuts in interest rates around the world too.

There is no dispute about any of that. There is however a serious debate about the scale of what should be done. You can always puff up economies for a few months with such policies, but the more you artificially boost them in the short term, the greater the problems a few years down the line. You can buy growth now but have to pay for it later.

You can see this most clearly by looking at the US during the two Bush administrations. The US bought its way out of the early 2000s downturn by cutting interest rates below the rate of inflation and giving large tax breaks. For a while the economy did fine, or so it seemed. But it was at the cost of creating an unsustainable housing boom and the build-up of huge debts by individuals and government alike. The private sector misbehaved of course, but it was the administrations that created the circumstances for it to do so. The US as a whole is weaker as a result.

We are in somewhat of that position here right now. There will be tax cuts and additional spending, to be announced in the pre-Budget report next Monday, but the scale and detail of the package is apparently not yet fixed. It seems that Alistair Darling is resisting pressure from Gordon Brown for a bigger boost, financed by yet more borrowing.

This can be played up into a clash between Chancellor and Prime Minister and there doubtless is some tension. But then there should be some tension between the two offices. The custodian of the nation's finances has a different constitutional role from that of the leader of the government.

My instinct here is that the judgement of the Chancellor is likely to be more right than that of the Prime Minister. The Treasury has, after all, to find the money and given the record of Gordon Brown over the past few years, I suspect that he would be more trusted than his predecessor by the world's financial markets.

There are at least three different reasons for concern about the scale of the boost that the Government is preparing.

The first is international. Trust is vital and there is a danger of a systemic loss of confidence in British financial management. Already sterling has fallen by as much as it did in 1992 when it was ejected from the ERM. We are going into this downturn with an exceptionally high budget deficit of around 4 per cent of GDP and that could rise to 6 per cent or more in the next financial year. It is plausible that the deficit could be even greater proportionately than the deficit run up by the Tories in the early 1990s.

The money has to be borrowed from the international financial community – there are not enough savings in Britain to do it. At some price a sovereign state (with the possible exception of Iceland) can always borrow, but the rates will reflect the risk, and the danger is long-term sterling rates rise sharply.

Second, there is the practical need to keep something in reserve. If you fire all your shots now, you are out of ammunition if they don't hit the target. Imagine a situation in the autumn of next year. We will be in the pits of the downturn. Interest rates will be down to 2 per cent or below. There will have been a temporary tax hand-back but the end of that will be in sight. House prices will still be falling and the economy will still be shrinking. And there will be nothing else that the Government can do.

We may not get there and let's all hope we don't but we cannot be certain that this recession will be short, or that there won't be a second leg to it after the initial downturn.

That is what happened to Japan in the early 1990s. It cut rates to near zero and had a huge public spending programme. Initially it did avoid a recession but at the cost of a deep one in the late 1990s and another in the early 2000s. Now it has debts of 180 per cent of GDP (against our 40-50 per cent) and is back in recession again.

Third, we don't want to make the mistake of America in the early 2000s of failing to make the essential adjustments that a recession forces on us. We have to save more. As individuals we have to do it, and people actually are making quite a bit of progress to that end. We are no longer, for example, taking out the equity of our homes and using it to support consumption. That change has been forced on us by the mortgage famine but makes sense anyway.

Companies are having to cut back, savagely in financial services and other vulnerable industries, including newspapers. And yesterday's statement by the Leader of the Opposition acknowledges that government will have to drive up its efficiency too.

It sounds harsh to say it and I don't mean it to be so, but recessions, slowdowns, squeezes, however you describe them, do serve a purpose.

They force efficiency. They force our whole society to figure out simpler and more effective ways of doing things. Increasing efficiency is the only way our whole society – not just a few talented or cunning individuals – gets richer. Why is Germany the world's largest goods exporter? Because its companies have lived through the fire, first of a high deutschemark and then joining the euro at too high a rate. Again and again the pressure on them has forced them to lift their game.

In an ideal world such pressure would be gradual and continuous. In the real world it comes from periods of harsh economic competition such as occur during a recession. It won't be a bundle of fun and people who are caught in the headwinds need to be supported by society as a whole. But the reward from the harsh period we are now entering is that we will emerge as a more efficient society, and I would hope a more equitable one too.