Hamish McRae: The swagger has gone, but what comes next?

There will be huge pressure on the next president to Do Something and that may lead to perverse policies

"It's the economy, stupid". That was the sign put up by James Carville, Bill Clinton's political strategist, in the campaign office during the 1992 presidential election. Now, come 2008, this looks like being the first US presidential election since 1992 when the run-up takes place against the background of incipient recession. In 1996 and 2004 the economy was growing decently and in 2000 the bursting of the dotcom bubble had yet to have much impact on the real economy.

We don't yet know whether the marked slowdown that is taking place in the States on the latest figures will indeed tip into the technical definition of a recession – two consecutive quarters of negative growth – but we do know that the economy has replaced Iraq as the main concern of US voters.

This matters in two ways. The first is obvious: the fear of tougher times will shape the campaign and the candidates will craft their pitches to respond to these concerns. Second, and I think more important, whoever forms the next administration is likely to do so against a struggling economy. That, in turn, will affect US self-confidence in areas that go far beyond the purely economic.

You can see the change of mood already. The swagger is gone. In the short-term, the present administration and the Federal Reserve are seeking to give a boost to economic demand by a tax-cutting package and by the latest interest-rate cuts. But if the price of US homes continues to fall, the positive effect on confidence of tax cuts will be more than offset by the negative effect of diminished housing wealth.

As for still-lower interest rates, well, already the country has negative real interest rates, in the sense that the Fed's key discount rate is lower than inflation. This is not sustainable for long. In any case, the problem in the US is not so much the price of money, but rather its availability and the willingness of people to borrow. A huge fiscal deficit and near-zero interest rates failed to stimulate the Japanese economy in the 1990s, after it experienced a property bubble, albeit a more extreme one than the recent US one.

So if the tone of the campaign matters, and I think it does, the economic background that the next administration inherits will matter much more.

The "R" word will be with us through the spring and summer, with a cat-and-mouse game over the economy as each bit of new evidence is jumped on and chewed over to see whether it supports the view that the country is indeed in recession or not. The reason is that you don't know for several months after the event quite what has happened and the early data is often revised. The biggest single element to almost every economy in the world is consumption, and in the US this is 70 per cent of the total.

Any early warnings of what might happen therefore attract a lot of attention. Just yesterday, The Conference Board, an economic forecasting body, reported that consumer confidence had fallen only slightly in January, which set the economy-watchers pondering that there might not be a recession after all. But this may be reversed in the next set of data. Confidence is particularly affected by items such as fuel because money spent on filling the tank is money not available to spend in the shopping malls.

Up to now, the people hardest hit by the slowdown and its associated rise in inflation have been the poor. Proportionately, they spend more of their income on food and fuel. The political issue now is the extent to which the squeeze people towards the bottom of the income scale are facing moves up the income range to that vast mass of the American middle class.

The disturbing economic feature here is that while the rich have been doing fine over the past few years, people on middling incomes have, on average, only been able to increase their standard of living by increasing their debts. Real disposable incomes have hardly risen at all during the past decade, if you allow for essentials such as health insurance.

Inevitably, the excessive borrowings have to unwind and that process seems to have started, either from choice or necessity. But of course as people pay back their debts, the income they have available to buy stuff shrinks. From a national point of view, borrowing to fill the country's homes with tat from China seems absurd but from an individual point of view it is not much fun to have to shop more cautiously. The candidates that best empathise with the insecurities of people who see their standard of living squeezed down will be the candidates that will garner most support. What a new administration can actually do is another matter.

But there will be huge pressure to "Do Something" and that may lead to perverse policies. The pressure to pump up the economy through 2002-05 led to what we now can see as dangerously low interest rates. Money was so cheap that to get a higher yield, banks were seduced into creating the sub-prime loans market. Banks could not earn enough by lending to the creditworthy so they lent to the un-creditworthy, fiddling around with the structures of the loans to make them look sounder than they really were. The Fed may make the same mistake again by cutting rates too far but the banking system is so blooded that it won't go back into sub-prime lending for a long time.

If – and this will be clear by this time next year when the next president is in office – cheap money will not provide the boost to the economy, what about tax cuts? There are limits there. The present administration has taken a lot of flak for its tax cuts, partly because they were angled so obviously towards the rich; partly because they appeared excessive, but the US federal deficit is now about 1.5 per cent of GDP, half that of the UK. Although it has much more leeway than we do, there are limits and as the economy slows, the deficit will rise of its own accord. So a one-off stimulus makes sense but four years of fiscal laxity does not.

So what is left? Here is the threat. Will the US become more protectionist? Will it seek to protect US jobs by restricting imports, particularly from China? We know Hillary Clinton has sounded alarmingly protectionist, but a president will be more constrained than a candidate. We just don't know much about how the various other candidates think, but we do know that there is a continuing paradox in US economic policy. On the one hand, it is a huge importer. On the other, it seeks to keep out many types of foreign goods, including agricultural produce.

So the next administration will be in the middle of a tug-of-war. Consumers will want cheap imports; producers will want to protect American jobs and, of course, their own profits. The slower the pull-out from recession, near-recession, stagnation, whatever, the greater this tension will be.