Reasons to expect a Nike Swoosh recovery

A failure of trust in global financial markets lies at the heart not just of the current recession but prospects for a sustained recovery in spending and jobs. Whilst journalists play the game of alphabet soup to describe the likely shape of the economic cycle, we might be better off thinking in terms of a Nike Swoosh. World growth is responding to an unprecedented policy stimulus but there is a real danger that the rebound inactivity will be constrained by a set of negative forces pushing down on growth. This was the message from Paul Donovan, Managing Director of Global Economics for UBS in his presentation to the Keynes Society last night.

Three forces in particular are likely to dampen the speed and durability of any upturn.

The dominant factor is the deep risk aversity of banks who simply do not want to lend to consumers and businesses. Flush with cash from quantitative easing they require households and firms to repay debt first before they accede to fresh lines of credit. The process of deleveraging (or repairing the damage) is taking much longer than expected. The US response has been to ntionalise the debt - giving Americans tax cuts and an opportunityto repay debt using their tax rebate cheques - whilst at the same time leaving their children to pay the higher taxes in the future.

A second driver is the collapse of returns for savers - this represents a huge transfer of income from savers to debtors - mortgage rates have collapsed and again given those up to their necks in property loans a chance to scale down their outstanding mortgages.

The third (and serious) problem is that facing smaller businesses. 60% of the economy comes from the small and medium sized business sector. And many more smaller companies rely on other similarly sized enterprises rather than the banks. Undoubtedly credit conditions for this sector have tightened and this makes it harder to conduct business and eventually take on extra workers.

A risk averse banking sector, tough cash flow problems for small businesses and the sharp reduction in disposable incomes of savers - three negative forces acting down on growth despite record low policy interest rates, a sharply lower exchange rate, £200bn of quantitative easing and a 12% fiscal deficit.

Paul Donovan argues that we are seeing a structural change in the economy - towards a higher level of risk aversion and a rise in risk premiums. The result is a steep fall in capital investment which ultimately affects the trend growth of labour productivity and thus the sustainable growth path for an economy. The new normal is a lower rate of growth - but with important changes in the pattern of demand as consumer behaviour changes. There are big opportunities here for 'green industries'.

Inflation is not the biggest risk - 70% of inflation is unit labour costs and wage inflation isn't going anywhere even if commodity prices take off again - the largest risk is weaker growth on a scale that means unemployment carries on rising putting even greater pressure on fiscal deficits, spending programmes and the tax burden. The return of trust is central to any prospect of economic recovery.