Hamish McRae: Spenders of the world unite

Economic View

The game has changed again, with the probability that the next move in global interest rates will be down, not up. The US markets in particular reckon that it will. It is also just possible that the Federal Reserve may move as soon as Tuesday, though this sounds too early. As for the Bank of England, it has signalled that it is prepared to cut rates if need be, though probably not at the MPC meeting this week. While there have been no signs from the European Central Bank, a double dip in the world economy would presumably shame it into action too.

But will lower rates boost the economy? Or are rates already so low that cutting further won't help much?

What is terrifying the Fed is that the US might catch the Japanese disease. In a world of modest inflation, it is always possible to cut the real burden of debt with the combination of very low interest rates and some inflation. But if there is deflation of current prices and asset values, even zero nominal rates may result in positive real rates. This has happened in Japan, where rates are in effect zero but demand has failed to grow. People (and companies) either don't want to borrow at any price, or are not considered sufficiently creditworthy (due to previous debts) to be able to borrow more.

There are two ways of discussing this – the issue that will, I now think, dominate the next five years. Can we ward off the threat that deflation will lead to economic stagnation, given that Japan has failed to do so? One way is to look at the differences between Japan and the rest of the world, at the failures of Japanese policies during the late 1980s and early 1990s, and at the structural weaknesses of the country's once-admired financial system. There has been a huge amount of discussion on these lines in recent weeks. The other way, which follows here, is to look more generally at the historical relationships between the economic cycle, deflation and growth and see what conclusions might be drawn.

The graph on the left shows the last 30 years of the economic cycle, fitting the industrial production of the OECD countries to the OECD leading indicator. Several points emerge. One is that the cycle seems inevitable. At no time during the last 30 years has industrial production been anything like a straight line. A second is that the most recent swings in industrial production have been quite muted compared with the 1970s. So while this cycle feels quite big, and indeed is big by the standards of the last 20 years, it is not at all off the screen.

And a third point is that if you believe the lead indicator, there should be pretty good growth in industrial production next year. So that is pretty positive. Even if there is a double dip later this year, there will be a good bounce soon afterwards.

So we don't need to worry too much about the state of the cycle. But the fact that the cycle turns up does not tell us an enormous amount about the durability or the strength of the upswing. What about the resilience of consumers in a period of falling prices? Consumption in Germany is stagnant – on the narrower measure of retail sales, it is running more than 4 per cent down year-on-year. Might US and UK consumers catch the Japanese (and maybe now the German) disease?

The best comparable period of history which combined falling prices, a globalising economy and rapid technical advance was 1870 to 1914. The UK called the first 25 years of that period "the great depression", not because there was no growth but because of the impact of falling prices on rents, particularly agricultural ones, and on agricultural products. It was depression of prices and the countryside, not of general output and the towns.

To see what happened to UK consumption in that period, look at the right-hand graph. It comes from the Bank of England's Inflation Report, out last week. In most years during this period of so-called depression, consumption rose. In fact, consumption never fell for more than one year and never by more than about 1 per cent. The worst years, 1921 apart when post-war reconstruction went awry, have been in the early 1970s and early 1990s.

Most people don't realise that even during the rest of the difficult inter-war period, which included the early 1930s recession, there were only two years when UK consumption failed to grow, and then it only shrank by less than 1 per cent.

True, the surge in living standards of the late 1980s and the string of 4 per cent annual increases of the last six or seven years look a bit abnormal when set against the 1880s or 1890s – or indeed the 1930s. But I think we know that an economy growing at an average 2.5 per cent a year, maybe 2.75 per cent if we are lucky, is not going to deliver 4 per cent increases in living standards for ever.

The common sense conclusion from all this? The very worse case would be that for a year in the future, consumption might decline. But only for one year. Even if the Bank of England were to fail and deflation to dig itself in, the chances are that consumers in Britain will carry on increasing their spending at an average rate of, say, 2 per cent a year. We like spending.

I am pretty sure the same conclusion could be applied to American consumers. They like spending too.

If this line of argument is right, then we can relax a bit. The US Fed and the Bank of England will do their utmost to avoid deflation and the balance of probability must surely be that they will succeed. No- one can be quite so sure about the ECB but it would be unfair to blame Europe's economic problems on a too-tight monetary policy. There are huge structural problems, particularly in Germany.

But even if the Fed and the Bank of England fail – even if falling interest rates do not immediately stimulate demand – the natural eagerness of consumers to increase their living standards will pull us through. The Japanese disease will not spread to the UK and America. Phew!