Recovery ... but we are not out of the woods yet

At the Bank of England, the corridors are still echoing more to the sound of cooing doves than screeching hawks

Sometimes, you really have to scratch your head a bit. The economic data have signalled generally upbeat news. Industrial surveys are consistently pointing to recovery, even if actual growth in the second half of 2001 was rather disappointing. Yet the financial markets remain very sceptical, with equities lower relative to the end of last year. Meanwhile, Messrs Greenspan and George are prepared only to be cautiously optimistic. Yes, the worst may now be behind us. But, no, there can be no guarantees of a rapid return to buoyant – and, perhaps, more importantly – sustainable economic growth.

What should we make of these cross currents? There are one or two reasonably straightforward conclusions. First, it's pretty clear, even with a recovery, there is no immediate risk of a return to higher interest rates. If there are doubts about the sustainability of economic growth, it would be a bit odd to take the risk of raising interest rates only to be blamed for creating a subsequent "double-dip". Knee-jerk financial market reactions that point to higher interest rates at the first sign of recovery should, therefore, be dismissed.

Second, if the recovery is ultimately constrained, the inflationary outlook should be subdued for a prolonged period of time. Indeed, to the extent that activity levels remain below where they should be – either because unemployment is too high or because there's plenty of spare capacity – there's a good chance that inflation may undershoot central bank targets. This leads to some interesting results. At the Bank of England, for example, the corridors are still echoing more to the sound of cooing doves than screeching hawks.

Underneath all of this, however, is an issue about recession and recovery. If the recession is shallow, what does this say about the subsequent recovery? This is a key question for policy makers today. The downswing through the course of 2001 proved to be relatively mild. Indeed, as Alan Greenspan said in his testimony before Congress last week, "the recuperative powers of the US economy ... have been remarkable".

Clearly, Mr Greenspan is hopeful that the worst is now over and, certainly from a data perspective, there has been plenty of good news recently. Yet he is never one to have his cake and eat it. Although the economy did not perform as badly as feared in the second half of last year, the US Federal Reserve chairman was quick to emphasise that "an array of influences unique to this business cycle ... seems likely to moderate the speed of the anticipated recovery".

Of course, these words simply emphasise that Mr Greenspan is a master of the "on the one hand, on the other hand" approach beloved of so many economists. Nevertheless, he has good reasons to remain concerned about the medium-term outlook, irrespective of the recent signs of economic improvement.

Here's a little story for you. A country has just been through a prolonged boom in economic activity. Asset prices have risen rapidly, far outstripping gains in indebtedness, either for consumers or for companies. The asset price bubble eventually bursts. There are fears of a collapse in economic activity yet, initially, these fears prove to be unfounded. Certainly, growth slows down but, unlike other countries, there is no significant contraction in economic activity. Indeed, on the so-called "technical definition" (two successive quarters of declining GDP), recession is avoided. Meanwhile, although asset prices come down sharply, consumers continue to spend rather than save.

Now, you're probably thinking that this is the US story over the past year or so – and, of course, you'd be absolutely right. Consumers have carried on spending. The economy has held up better than expected, continuing to outperform the likes of Germany and Japan (and, for that matter, the UK in the final quarter of last year). And the dollar has remained strong, suggesting an international vote of confidence in all things American.

Unfortunately, however, exactly the same observations could have been made about Japan at the beginning of the 1990s. The Japanese bubble burst at the end of 1989. Equity prices began their relentless decline, followed by land prices a year and a half later. The initial weakness in asset prices didn't seem to do too much damage. True, the economy began to slow down relative to the stellar performance seen at the end of the 1980s. However, relative to the performance of other countries, Japan continued to do well. In 1990, Japan saw 5.3 per cent growth compared with 1.8 per cent in the US and 0.8 per cent in the UK. In 1991, growth in Japan slowed to 3.1 per cent but, in the same year, GDP fell 0.5 per cent in the US and by 1.4 per cent in the UK. Meanwhile, the yen began a steady appreciation.

I would not want to suggest that the US is about to go down Japan's path. There are lots of differences – in economic structure, in the desire for profit, in the flexibility of the workforce, in the pace of productivity growth. These imply that America is a lot better placed to deal with the consequences of a sustained decline in asset prices. Nevertheless, Japan's experience does suggest that we should be careful in concluding too much from the initial stages of a decline in asset prices. The US may still be outperforming the rest of the world for the time being. But can we really be sure that this story will continue in the years ahead?

This question boils down to an issue about imbalances, factors that might constrain the ability of an economy to grow over the medium term. One way to think about this is to regard recession as unpleasant cleansing experiences – a bit like taking a cold shower with a lump of carbolic soap. The process might not be very pleasant but at least you come out more hygienic, if not smelling of roses.

Has the US been through this cleansing experience? To date, the answer is probably "no". The current account deficit is large and is likely to increase even further in the short term if the economy continues to rebound. Consumers have yet to increase their savings even with a major decline in asset values. Profits have seen the biggest decline in the post-war period and, to date, have shown no transparent signs of a rebound (indeed, transparency and profits have not exactly been obvious bedfellows recently).

Basically, we are not out of the woods yet. If anything, financial market indicators are pointing to more signs of distress. Risky assets, like equities, have fallen in value relative to "safer" investments like government bonds and cash. Banks continue to limit lending to the corporate sector. The commercial paper market has dried up. These factors all suggest that the current recovery may fade later in the year. The Fed's shot in the arm last year may have given the US economy enough strength for a short sprint forward but America's reputation as a long-distance runner may be fading.

Stephen King is managing director of economics at HSBC.