America sneezes and the world catches cold

There are two ways of looking at yesterday's emergency cut in interest rates by the US federal reserve, both equally worrying for the UK economy.

Either the Fed chairman has been panicked into action by crashing hi-tech share prices, which risks re-inflating a bubble that quite rightly should have been allowed to go pop.

Or he knows something deeply troubling about the state of the global financial system that the rest of us don't.

Notwithstanding figures published earlier in the week, showing US manufacturers experiencing the toughest conditions since April 1991, when the US economy was emerging from the last recession, there hasn't been enough evidence to suggest the real economy was the thing preying on Mr Greenspan's mind. After all, it was only a month ago that the Fed was leaning towards raising interest rates to contain inflationary pressure from an overheating economy.

The "hidden problem" scenario is perhaps the most worrying. As the aftermath of the Asian crisis two years ago showed, events on Wall Street have a habit of spreading like wild fire to other global financial centres, not least London, the biggest in Europe.

Falling shares prices and tightening credit conditions prevent companies raising money for expansion and quickly begin feeding through to confidence and jobs, not just in the City but in the wider London and UK economies.

If the first scenario is correct, and Mr Greenspan has simply bailed out greedy investors, he runs the risk of re-igniting an uncontrollable boom in asset prices which then begins to stoke profligacy by both consumers and companies.

In a tight labour market, where unemployment is down to 4%, that could lead to higher US inflation and interest rates. And where the US leads on interest rates, the rest of the world usually follows, especially the UK which is closely tied to the US through a complex web of trade and investment links.

The investment links are the most important. By the end of 1999, the UK accounted for $183bn (?122bn), or a fifth, of the total stock of foreign direct investment in the US from which its income is currently more than $12bn a year, according to the HSBC bank. That represents a third of the UK's income from abroad.

Movements in the value of British investments in the US economy, up or down, obviously have the potential to cause huge ructions in the UK economy.

The same is true of US investment in the UK. Britain is host to the bulk of US investments in Europe, much of it coming in recent years from hi-tech companies, now struggling to remain profitable. If more of them decide to scale back their activities, Britain will feel the pinch.

Figures out in London this morning offer a reassuring picture of the health of the UK economy. Mortgage lending is rising again, spending on the high street is picking up and growth in the service sector as a whole, which accounts for two thirds of UK GDP, is accelerating. On the surface, everything looks rosy.

But consumer and business confidence can deteriorate rapidly, especially when the word "recession" starts to appear regularly in the media.

In a global economy, when America sneezes everyone catches a cold. The US, which accounts for 25% of world GDP, may only have a sniffle at the moment but its condition has the potential to get much worse. Mr Greenspan has administered one dose of medicine already; he may have to dispense more.

Useful links
4 January: London shares soar after US rates cut
4 January: Greenspan rallies markets
4 January: US rate cut may spark UK move
4 January: Notebook: Greenspan sticks his neck out

Useful link
Press release: Interest rate cut - US federal reserve