Kick-start strategy fails to fire spluttering US economic motor

Recovery in the recession-hit US economy will be under way by the second half of the year, if share prices on Wall Street are to be believed. But what, exactly, does "recovery" mean?

"Recession" in the US is defined as two consecutive quarters of negative growth, with the corollary that positive growth, however small, qualifies as a recovery. But there is no significant difference between a decline of 0.1% per annum and growth of 0.1%; both are so far below the growth of productive potential that they would be experienced as increasingly severe recession if continued for any length of time. No growth rate much below 3% should be called "recovery" at all, since unemployment would be rising; profits and capacity utilisation falling.

Public discussion is further distorted by Wall Street's obsession with the very short term. People who want to make money on the stock exchange try to predict what will happen during the next few months. But strategic policy formation, particularly with regard to fiscal policy, requires a time horizon several years ahead. "Fine tuning" has decisively and permanently been discredited.

Taking such a strategic view, my belief is that, in the absence of a further large and rising stimulus from fiscal policy, the US recession will continue for several more years, at least in the form of seriously sub-normal growth, while it is easy to imagine circumstances (a world slump or a stock market crash) which would cause the absolute decline to continue.

The 90s expansion was powered uniquely and exceptionally by a huge fall in the net saving of the private sector, the scale of which is illustrated in the chart. Vertical lines mark the first quarter of 1992, when the expansion really got going, and the third quarter of 2000, when the slowdown started.

During this period the balance between the private sector's income and expenditure fell by 11.5% of GDP; in the third quarter of 2000, private expenditure exceeded income by an amount equal to 6.2% of GDP, never having exceeded it significantly at all during the previous 30 years or more. This could not have happened without a huge rise in borrowing, which made the private sector as a whole far more indebted than ever before.

The subsequent recession has clearly been associated with a reversal of this tendency. There has been a sharp fall in private expenditure relative to income since the third quarter of 2000. Yet, in the third quarter of 2001, the private sector deficit was still nearly 2.5% of GDP; much higher than in any earlier period and still enough to require so much borrowing that private debt relative to GDP rose to another peak.

The private deficit will probably recover all the way back to its normal condition of surplus, implying a continued fall in private expenditure relative to income, withdrawing 4.5%-5%, up to $500bn (£342bn) from aggregate demand. But even if the private deficit were not to recover at all, my main conclusion would still stand because the US economy would remain deprived of the motor which drove it through the 90s.

Total demand and output in the rest of the world is unusually stagnant, so net export demand may not rise at all, while the Congressional Office's fiscal projections imply no stimulus beyond the injections under consideration.

A number of factors may combine to lift aggregate demand in the very short term. A tax rebate has put $40bn into the hands of US consumers in the third quarter of 2001. This has been written off as too small to count, with GDP at about $10 trillion per annum. But while the rebate is indeed less than half of 1% of a year's flow of GDP, it was 1.6% of GDP arising in the third quarter - quite enough to have a perceptible effect on spending.

Second, the huge fall in short-term interest rates has reduced mortgage rates to their lowest level for decades, lowering the interest burden on households and resulting in substantial withdrawals of equity from the housing market.

Third, there is bound soon to be a recovery in inventory investment which was heavily negative in the third quarter. And car-buying has surged as a result of zero-interest credit inducements.

All of these influences will be having a positive effect in the immediate future. However, some of them (the rebate, the equity withdrawal) will be "blips" in the sense that their effects are once-for-all and self-reversing. Others (lower interest payments and the rise in inventory investment) while not self-reversing are nevertheless once-for-all steps, while the car splurge is likely to be self-cancelling since sales have been "stolen" from 2002.

So, none of the factors tending to stem the recession in the short term will generate any enduring motor for expansion over the next few years. There is a strategic need, if "growth recession" is to be avoided, for a new motor to drive the economy, particularly if there is a further decline in private expenditure relative to income which could generate a further hole in aggregate demand worth $400-$500bn. So don't get over-excited if the US gets a few good looking numbers in the next two or three months.

· Professor Wynne Godley works at Cambridge Endowment for Research in Finance