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It’s time to face the impact of a US recession and accept the price of unfettered growth

BY Tony Dolphin

There can be no doubt that the US economy is in recession, although it may be several months before this is confirmed by the National Bureau for Economic Research, which is the official arbiter of such things. Employment fell in each of the first three months of the year, by a total of 232,000.

This has never happened before except in recessions or in the periods immediately after them. Meanwhile, consumer confidence has slumped and household spending growth was much weaker in the first two months or the year. When the official figures are available, I expect US output to have contracted in the first half of the year.

Why is this happening? First, the collapse in the US housing market, which began over two years ago, has spilled over into the rest of the economy. Falling house prices make households feel less wealthy and so less inclined to spend. Second, record food and oil prices leave households will less to spend on discretionary items.

This has implications for the rest of the world. When the US slowdown was confined to the housing market, it had little effect on the rest of the world. Now that it has spread to consumer spending, it will have a bigger impact. Slower growth in US consumer spending will mean weaker US import growth and this will mean slower export growth in other countries. The US is still, by some distance, the world’s largest economy and US consumers are still the world’s main source of demand.

Global headwinds

This is not the only reason to expect slower growth outside the US. There are a number of global head winds to growth that will affect most regions of the world this year.

In the last six months equity markets have fallen across the world. This represents a loss of wealth and so could be a drag on economic activity. It also raises the cost of equity finance for companies.

Oil, food and other commodity prices are at record levels. By pushing up prices of goods and services that are essential they leave consumers with less to spend on discretionary items. Higher commodity prices also push up inflation. For some countries, especially in the Asia and Pacific regions, this is a real concern. In economies as diverse as China, where inflation is at a 12-year high of 8.7%, and Singapore, where it is at a 26-year high of 6.5%, the authorities are acting to slow economic growth as a means of controlling inflation pressures.

Then there is the credit crunch. Financial institutions, faced with massive losses from their investments in securities related to the US mortgage market (the IMF now thinks these will total $945 billion) are cutting back on their lending activity. Ultimately, this will limit the ability of households and companies to grow their spending.

So global economic growth is likely to be a good deal weaker in 2008. After averaging around 5% during the last four years, growth will slow to about 3% in 2008. This is far from a disaster – in 2001 growth was just 2% and in 1991 it dropped below 2% – but it is unwelcome nonetheless.

More importantly, unlike most forecasters, I do not see things getting any better next year. The lingering effects of the US housing market collapse, soaring commodity prices, tighter economic policies and the credit crunch will be holding back economic growth for much of 2009. To understand why this could be the case, focus on the UK economy. Although growth slowed here during 2007, it was still around its trend rate in the second half of last year and the first few months of 2008.

This is unlikely to last much longer. Households, whose spending represents over 60% of economic activity in the UK, are now under enormous pressure. Throughout 2007 and the first few months of 2008 price inflation has been higher than average earnings growth, meaning most households have had their spending power reduced.

House arrest

Meanwhile, the housing market is deteriorating at an alarming pace. Mortgage approvals have fallen by 40% over the last year and prices, according to the Halifax, are down 1.3% over the same period. And now the mortgage market is disappearing. Lenders are withdrawing products, increasing interest rates and fees, and requiring larger deposits before making offers. By the end of 2009 house prices in the UK could be down 15% from their peak levels.

Historically, whenever the housing market has been this weak, the UK economy has been close to, or in recession. The next two years are unlikely to be any different. The same pattern could be repeated across large parts of the globe, including the euro-area, causing world economic growth to slow during the rest of 2008 and to remain weak in 2009. The biggest credit boom in history was never going to end without some sort of economic turmoil and two years of weak global economic growth looks like the price we’ll all have to pay.

Tony Dolphin is director of Global Economics and Asset Allocation at Henderson Global Investors and a member of the Society of Business Economists