Lessons from the past teach caution now Worldly Wise

Talk about green shoots of recovery has been lately replaced with talk about cautious optimism because people realised that they should not be carried away with the mixed signals that were emerging. Too little time has passed since the beginning of the crisis to be able to make an accurate assessment though there are genuine signs that the rate of economic decline has decreased and there is a possibility that we will see some modest growth figures in the second quarter next year.

The Greek teachings tell us that you need to define a problem before you can solve it. This is what I want to attempt to do in this column, since I do not believe that this crisis came out of a clear blue sky and that no one saw it coming.

I recall reading an article when I was in university in 1999 that basically summarised what is happening today in the economy. It basically said that the economic growth in the US in 1999 and the previous years had been based on consumer debt. Individuals were not only believing they were richer due to rising house prices, they also took out more loans and used their existing homes as collateral. This was putting a strain on the mortgage market and people's saving rates were in the negative. Should economic growth continue people will need to borrow more but would be unable to do so because of mounting interest rate payments and so a recession is on the horizon.

It is therefore fair to ask, why the recession that should have taken place in 2000 never happened. George Bush was elected president and he immediately introduced massive tax cuts. He based it on a government surplus everyone knew would not exist for long because of the fear that the "dot com" bubble was about to burst.

Which is exactly what happened but here again someone was there and ready to manipulate the business cycle by cutting interest rates. Federal Reserve chairman Alan Greenspan cut interest rates and the people were allowed to continue borrowing and spending. Then came two wars and the Bush administration and the Congress hardly rejected a spending proposal.

The imbalances that were obvious in 1999 had become so great in 2008 there was now no way to avoid them. Individuals were so heavily indebted in the US some were even using credit cards to pay for their mortgages. To finance their consumption some people had taken out multiples mortgages hoping the housing market would continue to rise.

The mortgage market collapsed because speculation had increased house prices to unsustainable levels. Governments and financial institutions encouraged this behaviour because for economic growth to continue people will need to borrow more and they enabled them to do so.

It is true that stimulus packages have slowed down the rate of economic decline. But their actual objective was to reinvigorate the economy and produce economic growth. This is why Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Gietner are worried because they know the government cannot spend forever and that private consumption needs to pick up. But this is unlikely to happen anytime soon because people are trying to sort out their finances which they so spectacularly messed up in the past decade.

It will take some time before people in the US have the confidence to spend again especially while unemployment rising.

The writer is an economist and independent consultant in Vienna, Austria