Economy, heal thyself - with a little help

THERE was much relief on Friday that the Group of Seven seemed to be putting together a credible plan to stabilise the world economy - though it is hard to distinguish the effect of the G7 statement from the effect of better than expected US growth numbers. I suspect the latter was actually far more important.

But that does not mean we should dismiss the G7 initiative. What everyone in the world of economics and finance has been seeking is confirmation that the monetary authorities in the main developed countries realise that (a) there is a problem, and (b) they may need to act together in a determined way if that problem is to be contained. Whether the plans are adequate or appropriate is almost less important than the fact that the G7 seem to be taking things seriously. The world's bankers are seriously worried; they were worried that the officials were not worried; now they know they are.

The actual substance of the G7 plan is quite limited: an emergency fund run by the International Monetary Fund, as suggested by President Clinton, further funds from the World Bank for the poorest nations, and greater co-operation between global regulating agencies. There is nothing wrong with this; on the contrary a piecemeal approach to monetary reform is much more likely to be successful than a grand plan. But if, as seems likely, the recession deepens, the plans so far announced might appear a little under-powered.

The most helpful guide to the future economic cycles are past ones, partly because you have to have some sort of a frame of reference but also because the economic cycle is such a durable creature that we can learn from previous experience. I am grateful to Bill Martin, of Phillips & Drew, for digging out a host of data about British economic cycles since 1870, which do give such a frame of reference and, I think, carry some lessons for the future. The chart on the left shows the big picture - the deviation from trend growth of the ups and downs of the cycle. Note that these figures are simply measuring the size of the swings; they are not saying anything about underlying growth rates or the level of inflation.

As you can see, during the period between 1870 and 1914 there was a regular cycle with a seven-to-10- year range. In the early part of that period, the amplitude was not marked, but there was a big swing around the turn of the century. During the inter-war years there was a violent cycle, with the early 1930s showing the deepest trough for the past 130 years. In the immediate post-war period the cycle was dampened down until the early 1970s, when big swings similar to those of the late 19th century resumed. Our own memories are of the early 1980s recession, the late 1980s boom and the early 1990s recession. These felt pretty big swings, certainly to anyone who bought a house in 1988, and they were by historical standards. In fact you could have gone through from 1870 to 1890, which was called the Great Depression until the much greater one of the 1930s, without experiencing as large a cycle as we have had to cope with in the past 20 years.

What about timing? The chart on the right shows how the bigger the amplitude of the cycle, the longer the duration. That makes sense. The longer the boom carries on, the higher it is likely to get, and vice-versa. The seven-to-10 year cycle of the last century (and since 1980) gave way to a four-to-six-year cycle in the 1950s and 1960s. Which is more normal? I think you would probably have to say the 1950s and 1960s were the aberration rather than the norm.

Can you tell the size of the slump from the size of the boom? It would be nice if you could and I suppose to some extent the higher they go the harder they fall. But it is not an exact relationship. True, the trough was particularly deep after the high peaks of both 1889 and 1929, but it was not very deep after the even higher peaks of 1899 and 1973. The fact that the recent upswing did not get out of hand ought to mean that the coming downswing will not be serious. I like to think that; if you are going to have pain you ought to have had some fun first. Sadly, history does not give much support to this thesis.

If, however, we are going into an eight-to-10 year cycle, and if the peak turns out to be this year, then the chances are there will be a bottom around 2000-2002 and another peak between 2006 and 2008.

How deep might the bottom be? The P&D research suggests that if we are in for a classical 19th-century cycle there will be a year of negative growth in 1999 or 2000, perhaps minus half a per cent. If, on the other hand, the cycle is more like that of the 1950s and 1960s there would be a shorter cycle and merely a year or two of slow growth, say 1 per cent. How can we guess correctly which sort to expect?

Well, we can't. The only sensible way to look at the coming downswing is to see what will cause it and how these causes differ from the things that have triggered previous cycles. The most alarming precedent of course is 1929, where there was a collapse of world trade and of many countries' banking systems, including the US. That is the fear behind the G7 statement on Friday. Essentially the G7 is saying that if things look really dreadful, it will act in a more effective way than its predecessors did then.

That seems to me to be wholly credible. You have to assume a very high level of stupidity and incompetence for world leaders to make as big a mess now as they did at the beginning of the 1930s. On the other hand the mild cycles of the 1950s and 1960s, under the Bretton Woods fixed exchange rate system and (more importantly) under the economic domination of the United States, are already out of the window. What has already happened in Asia provides a much bigger shock than anything experienced during that period. The shock provided by the Asian crisis feels much more like the first oil shock, except that it is the mirror-image: a deflationary shock hitting an already deflating world instead of an inflationary shock hitting an inflating one.

On the other hand I don't think we can assume the policy response to the present set of shocks will be optimal. They won't be really stupid, but they won't get it right. The world's financial leaders have already made a number of mistakes: Japan has been too slow to shore up its banking system, the IMF has failed to understand the dangers of a deflat- ionary spiral in East Asia, the US has allowed the boom to carry on too long and build up a vast current account deficit, and continental Europe has followed policies that create an unacceptable level of unemployment for the peak of the cycle. If they have not got things right so far, there is not much reason to expect them to get things right from now on.

Mercifully, the world economy is self-healing, as the 19th century showed. So the sensible outlook would seem to be for a middling cycle, something much more like the cycles between 1870 and 1914. Those charts, of course, show British data rather than world data, but it is a good enough proxy for the way things might turn out. The key point here is surely whether we can do a bit better than the other developed nations in scrambling through the coming downswing. Are we more nimble and thoughtful in our economic policies? Have we a flexible monetary policy? And a realistic set of fiscal projections?

Assume that the grand economic management at a G7 level is more or less OK. Hope that the more modest economic management at a national level turns out to be as good as, or ideally a bit better than, the rest of the pack.