The next great depression? EVEN BEFORE the tragic events of September 11, the US economy was headed for trouble. Asset prices were falling and consumption, which had hitherto offset steep drops in business investment, started slowing. It seemed almost certain the US would head into recession, if it was not already there. To do maximum long-term damage, therefore, the terrorist attack could not have been better timed. To begin with, by shutting down much of the US economy for a few days, the incident almost certainly tipped it into recession. More significantly, though, the cost of reconstruction, bailouts and increased security expenditure will drive up government spending, probably putting the budget back into deficit. This will put an end to the US government's policy of paying down its debt. Already, long-term interest rates have resumed rising. This will therefore complicate the Federal Reserve Board's efforts to restore growth with interest-rate cuts. In short, the fallout from the incident is likely to slow recovery. Most American analysts remain fairly bullish on the future prospects, though. They point out that hundreds of billions of dollars in stimulus from interest-rate cuts and tax rebates are already in the pipeline. Meanwhile the US Congress is readying a further stimulus package. Therefore, reason the optimists, in a matter of months the American economy will be back to full speed. Perhaps. Yet it is worth bearing in mind that the Japanese have been pumping huge amounts of money into their economy over the last decade. Each injection staves off collapse, but once it runs its course, recession returns. Looking at the tax cuts, I do not see much stimulus coming from them. As is well known, most of the money went into the hands of the rich, whose marginal propensity to consume is not high. And while they might be tempted to invest the money, thereby restarting the economy, there remains the problem of excess capacity. During the 1990s boom, a speculative binge led investors from Taipei to Toronto to build factories and plants on the assumption that future demand would continue to grow exponentially. The decade's politicians egged them on by talking up the virtues of the so-called new economy. The most notorious example of this, of course, was the Internet bubble that drove the NASDAQ index into the financial stratosphere. The bubble has now burst, and it will be a very long time before valuations return to their previous levels. Indeed, they may yet go lower. Part of the problem, from what I can tell, is that the 1990s stock market bubble was inflated largely by small investors using borrowed money. In the days when credit was cheap and returns high, it made sense to borrow to buy shares. But now that assets have fallen, it appears the process has gone into reverse. In the last couple of months, there is evidence that small investors have been liquidating their stock market holdings to pay off their debts. If this pattern holds, it means we are probably in for a long bear market. And given the extent to which Americans own shares, this will in turn depress consumer confidence until the stock market goes back up. Recovery may therefore be slow. Right now, the global economy is entering a situation it has not found itself in since the 1970s: all its major poles are slowing at once. Japan is in a deepening gloom, the US is probably in recession, and now the European economy is slowing quickly. As demand from these economies drops, it is creating spin-off effects in neighbouring economies. Further complicating matters is that increased security measures over the coming years may have an inhibiting effect on trade. Protectionist sentiment had been on the rise before September 11. The trend now seems likely to accelerate. Reduced international trade could, as happened in the 1930s, turn a short-term recession into an outright depression. What does seem clear is that we are in uncharted territory. The oft-expressed view that war is good for the US economy holds only true if, as was the case for America's 20th-century wars, it is fought on someone else's soil. This war, and its effects on consumer sentiment and investment, will be much closer to home. It is, therefore, a time for caution. John Rapley is a Senior Lecturer in the department of Government, UWI, Mona.
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