Inflation was the economic enemy of the past decade. But today a different danger looms: depression. John Plender examines the prospects for property
“Are we heading for a 1930s-style depression? Has inflation finally been conquered? Are equities about to go out of fashion–and will property be little more than a fixed-interest investment for the foreseeable future?
These questions, which all reflect different aspects of the same underlying economic phenomenon, increasingly crop up when trustees and fund managers discuss asset allocation. There is a widespread sense in the financial community that we might just be confronting the unthinkable: a global recession which turns into depression.
At a superficial level there are plenty of reminders of the boom and bust of the 1930s. In Britain we are experiencing the longest recession since the war. The US economy obdurately fails to pull out of the trough, despite a succession of cuts in interest rates. Japan and Germany, arguably the real victors of the cold war, are suddenly slowing down very sharply.
More important, the boom which preceded the recession was characterised, in the English-speaking countries, by a heavy build-up of debt. The excesses of the boom have been followed by excessive monetary discipline. As a result the leading industrialised countries have, indeed, experienced the highest real rates of interest since the slump.
And, in the US, where nominal interest rates have been cut time and again to the point where real interest rates are now at more normal levels, the transmission mechanism between lower interest rates and economic recovery seems to have broken down.
Nor are all the deflationary pressures in the world economy purely cyclical. Technological deflation has been gathering pace — witness the speed with which the prices of consumer electronics products such as videos and calculators come tumbling down.
So, too, is the emergence of a global labour market. Today the teeming masses of Asia and Latin America provide multinational companies with the opportunity to operate at a lower cost base than in their home economies in the developed world. That adds a very powerful deflationary bias to the world economy.
But does it follow from this that we really are witnessing the end of the great inflation which began in the early 1970s and that depression is inescapable? If the argument works, it works best in the United States, where the failure of the Federal Reserve Bank’s successive interest rate cuts to crank up the economy has recalled Keynes’ description of monetary policy in the 1930s depression as pushing on a piece of string.
In the meantime. President Bush’s budget deficit already exceeds $300bn, so there is no room for a public works programme on the scale of the New Deal. And there are growing tensions of the Uruguay trade around which are carried an uncomfortable echo of pre-war protectionism.
Nevertheless, there is a point at which the comparison with the 1930s breaks down. At that time, millions suffered losses as a result, first, of the 1929 crash, then of a series of banking collapses. The resulting lack of confidence, combined with falling asset prices, high real interest rates and high unemployment, encouraged people to hold more of their wealth in the form of ready cash. The temptation to borrow and spend was minimal.
This time the US has once again seen a rash of collapses in the savings and loan sector of the banking system. But deposit insurance has mitigated the damage for the individual at the cost of increasing the federal budget deficit. In the commercial banking sector, meanwhile, profitability has collapsed under the weight of bad debts in real estate.
However, that helps to explain why the Federal Reserve Bank’s interest cuts have not done the trick: the banks are not cutting to the same extent as the Fed because they want to restore their margins and their capital base. Money is cheap; but credit is rationed by the fear which prevails in banking parlours.
That is not a process which President Bush or Fed chairman Alan Greenspan wish to see continue. A confidence-building State of the Union message has already indicated that the president will take any remotely expansionary fiscal step he can in pursuit of victory in the November election. In the interim, Greenspan will go on cutting interest rates until something finally happens.
And the equity market, contrary to the experience of the 1930s, is cheerful. True, the debt work-out, as the bankers call it, is painful. But interest rates are now approaching levels where old borrowers are busy refinancing mortgages and loans and new borrowers will be tempted to put a toe in the water.
Real interest rates are no longer high in the US, so the personal sector’s liquidity preference looks set to erode against the background of a surging equity market.
Europe is another matter. In the United Kingdom real rates of interest remain high, since they are dictated by the Bundesbank. The German steel workers’ pay settlement at a British-style 6.4% last week means that the Bundesbank will now feel obliged to keep on the pressure for longer. To make matters worse the Maastricht treaty proposes a set of rules for fiscal policy en route for monetary union which are absurdly deflationary.
Some people argue that this amounts to a cast-iron case for abandoning equities in favour of gilts. But the political pressure is mounting on politicians to play fast and loose with the Maastricht rules. Already British fiscal policy is on an expansionary tack and will look more expansionary after a pre-election budget. And the British are not alone.
My guess is that the first half of the decade will see a low-inflation, low-growth world economy, but no depression.
Property will remain as it always has been: a cyclical investment that offers low growth in the first half of the 1990s because of a huge build-up of excess supply rather than some devastating collapse in the economy.
Perhaps we are too easily mesmerised and frightened by the word “depression”. Never forget that, between 1932 and 1938, despite all the horrors, Britain experienced its highest rate of economic growth this century.”
