Why you should be preparing for the next recession

The recovery has put a smile on everyone's face, says Matthew Lynn. So, now's the time to plan for the next downturn.

We have the fastest-growing economy in the developed world. Unemployment is coming down fast. Sterling is strong, real (after-inflation) wages are growing again, and house prices are booming. After a long recession, the British economy is coming up trumps. Even our downbeat chancellor, George Osborne, looks cheerful.

There is only one problem. No one seems to have noticed that another recession is just around the corner. Just because the crash of 2008 and 2009 was deeper than any since World War II, and output has barely crept back above its earlier peak, does not mean that the business cycle has been abolished.

Judged by the historical record, another downturn is due any moment. That will mean that a hike in interest rates can be forgotten, more quantitative easing (QE) will be unleashed, and the already enormous budget deficit will balloon even further.

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That seems a long way from today's discussion about the British economy.All the talk now is over how far and how fast growth can accelerate from here. Only this month, the International Monetary Fund, which had earlier criticised the government's austerity programme, upped its growth forecast from 2.4% to 2.9% for 2014, making the UK the best-performing nation in the G7 group of rich nations.

There is also plenty of talk about when the Bank of England will start to normalise interest rates from their 300-year-lows, with most City economists pencilling in 2015 for the first hikes. Inflation is low, and wages are finally growing faster than prices.

It would be nice if that could continue. After all, for most workers real wages are still lower than in 2008, house prices outside central London have still to recover their old highs, and the budget deficit (the gap between government spending and the tax take) is still set to come in at a terrifying £107bn for 2014.

The recovery feels like it has only just started, and there is not yet much of a feel-good factor. The trouble is, this is probably as good as it gets.

There is an old adage that every five to seven years everyone forgets that every five to seven years there is a recession and history suggests it's true. During the post-war period, according to the National Bureau of Economic Research in the US, the average length of an economic expansion has been 58.4 months (pre-war it was 35 months, and in the Victorian era just 26). Where are we now?

The British economy fell off a cliff in 2009, and in the second and third quarters of that year shrank by 2.1% and 2.5% respectively. At the start of 2010, it started growing modestly again. Yes, it shrank during two quarters in 2012.But that looks more like a statistical blip, due to very sluggish growth.

So if you date this recovery from the start of 2010, it has now been running for 54 months. The same is true in the US. It started recovering in the final quarter of 2009 and never dipped back into recession, so its expansion has been running for 57 months. Whichever way you look at it, time is just about up.

Of course, it might be different this time. The depth of the recession might mean there is more slack in the economy, allowing it to grow for longer than in earlier recoveries. Businesses might have more cash to invest, and will carry on spending. Consumers might be so relieved at finally seeing their wages grow that they will keep on shopping. Then again, maybe not.

It very rarely is different this time. The smart money bets that the future will be much the same as the past. The business cycle has not been abolished it is just operating from a lower base. That means the next cyclical downturn is getting very close. And that will change what everyone right now expects to happen to the economy.

First, forget about a hike in interest rates. The Bank of England has been dropping hints about the first rise coming some time around next spring. But if the economy has turned down by then, that will quickly be dropped. Rates can't be cut in any significant way from 0.5%, but they are not going to be raised in the face of a shrinking economy.

Next, expect more QE. Whether it worked last time around is still open to debate, but as there isn't any other tool available, the chances are the Bank will crank up the printing press again.

Last time around £375bn was pumped into the economy. But that was accompanied by cuts in interest rates. Since they can't be cut any more, QE will have to do the heavy lifting by itself so expect at least £500bn, or around 30% of GDP.

Finally, expect the budget deficit to balloon, from already very high levels. The UK went into the last recession with a small deficit, and turned it into a huge one. It will go into the next one with a deficit of more than a £100bn. As tax revenues tumble, as they always do when the economy shrinks, that will rocket. At least £200bn seems likely. The modesty of austerity so far will be cruelly exposed.

Gordon Brown claimed to have abolished boom'n'bust'. It wasn't true then, and it isn't true now. Another recession isn't what anyone wants, and it won't be pleasant but it is better to be prepared for it than to be taken by surprise.

Matthew Lynn

Matthew Lynn is a columnist for Bloomberg, and writes weekly commentary syndicated in papers such as the Daily Telegraph, Die Welt, the Sydney Morning Herald, the South China Morning Post and the Miami Herald. He is also an associate editor of Spectator Business, and a regular contributor to The Spectator. Before that, he worked for the business section of the Sunday Times for ten years. 

He has written books on finance and financial topics, including Bust: Greece, The Euro and The Sovereign Debt Crisis and The Long Depression: The Slump of 2008 to 2031. Matthew is also the author of the Death Force series of military thrillers and the founder of Lume Books, an independent publisher.