Great thirst for stable economy

AS the old adage puts it, you can lead a horse to water but you cannot make it drink. Stockbrokers may disagree, having successfully taken herds of investors to the trough recently, patting their flanks and murmuring about 'exceptional drinking opportunities'.

But Federal Reserve chairman Alan Greenspan must be more worried about his particular horses - those from commercial stables. Despite his encouragement, they are reluctant to drink.

Since February, the level of commercial and industrial lending by the banks has fallen by over 5%. To find as fast a fall, we must go all the way back to the late 1970s, in the wake of the rocketing oil price crisis.

We may be confronting what the economists call - appropriately for my rather overstretched metaphor - a liquidity trap. The normally powerful monetary levers do not seem to be working, Despite 10 interest rate cuts in 11 months, the US economy will grow by only 0.7% next year, according to the International Monetary Fund.

Eyes are turning increasingly to Japan, not just because of its interminable crises but because it is providing a laboratory for observing a liquidity trap. Official interest rates are virtually zero, yet the economy is heading once more into a serious recession. The public and business won't borrow.

It is understandable given that the country is also suffering deflation, i.e. falling prices. It makes sense to postpone purchases if goods will be cheaper later; to save rather than spend if the financial crisis threatens employment.

Deflation also means that while official interest rates seem absurdly low, in real terms - i.e. after allowing for deflation - they are significantly higher.

Japan is, of course, special, with banks allowed large portfolios of industrial holdings and real estate, so that their creditworthiness has collapsed. It is certainly no help to global recovery that the world's second biggest economy is in such a hopeless mess.

American banks are more sanely run. All the same, if deflation sets in - or, equally important, is widely anticipated - then the Fed's mere 2% interest rate would not seem so wonderfully low. The US has suffered this sort of problem in the 1930s. Rates were slashed from 6% at the time of the 1929 crash to 1.5% and later to 1%. But it was a long time before the great slump ended.

Britain also suffered in this period with interest rates at 2% from 1932 to 1938 but still desperately slow in providing the hoped-for stimulus, not least because the cost of living fell every year in the first half of that decade.

The chances of deflation in the US cannot be ruled out. Import prices are now down more than 7% on a year ago, aided by falling raw material prices; and with oil prices still cheapening, that index could fall further.

Unemployment has been rocketing and the public's savings ratio has shot up. A liquidity trap is no longer unthinkable. Greenspan should cut again. But, with rates at 2% now, the scope for monetary policy is looking limited.

The chances of the eurozone confronting deflation would seem less. But the European Central Bank - interest rates at 3.25% - has been slow to recognise the deteriorating prospects. So it cannot be ruled out there entirely.

Britain would seem the odd one out, with most indicators in good shape and inflation, though likely to fall, still expected to be mildly positive. If we do manage to stay healthy in isolation - and the signs are reasonably encouraging - it will be quite an achievement.

For the markets in general, there seems to be no such thing as bad economic news at the moment. As the indicators slide, the reaction seems to be that the US will put the Western economies to right with more rate cuts. Investors should appreciate that Greenspan is beginning to scrape the barrel.