Just a mild case of the Reinhart and Rogoffs

I DON'T know about you, but I'm increasingly confused about what's really happening in the economy. The headlines are more and more downbeat. However, I keep meeting people who tell me demand in their own businesses is holding up surprisingly well. Even through a dark, wet January.

Some seem almost ashamed to admit as much, given the prevailing gloom about the consequences of recent turmoil in global financial markets - the rapid slowdown in demand in the real economy is already well under way, we are told.

Conventional wisdom has it that in the US, where the sub-prime crisis first erupted, recession is now all but inevitable. But that's just the start of it. Dire predictions of a world tottering on the brink of recession and fears of a Thirties-style deflationary slump are becoming increasingly commonplace.

Some commentators are even suggesting that, given its purgative qualities, a recessionary interlude - albeit a brief and shallow one - will be no bad thing if it weans us all off recent excesses, like spending too much and financing that consumption by unsustainable levels of borrowing.

Are there substantive grounds for these bleaker scenarios? There is certainly widespread suspicion that financial markets - thanks to unsustainable business models, product alchemy, lax regulation and a new generation of rogue traders - have become too clever by half.

And that any return to a more soundly-based set of operational principles will generate some consequential pain for everyone dependent on banks for growing their own businesses.

But can anyone say, with any degree of certainty, that this latest crunch will deliver a knock-out blow to hopes of continued growth in the world economy?

Well, two distinguished American economists have tried to benchmark the consequences for the US of this financial crisis against its predecessors. Carmen Reinhart and Kenneth Rogoff have compared the first major financial crisis of the 21st century with the Big Five such crises of the latter half of the 20th century and 13 other significant, but less serious crises over the same period.

This one, they write, "involves esoteric instruments, unaware regulators and skittish investors.

It also follows a well-trodden path laid down by centuries of financial folly". Its Big Five predecessors - Spain (1977); Norway (1987); Finland (1991); Sweden (1991) and Japan (1992) - were all very expensive to clean up.

Recovery from Spain's banking crisis in the 1970s cost more than 16% of GDP, while Japan's lost decade is estimated to have consumed as much as 20% of GDP or more. The Norwegian and Swedish crises cost 8% and 6% respectively. Might sorting out this one prove to be any less ruinously expensive?

Reinhart and Rogoff chart changes in asset prices, real economic growth and public debt in the run up to this crisis compared with earlier ones. The rises in real housing and equity prices in the US this time have exceeded what happened even in the Big Five crises of the recent past.

The US current account deficits in the four years leading up to this crisis are also markedly worse than the average back then. However, American GDP growth, while following the average pattern of past crises so far, shows less of a dip to date than the Big Five.

And public debt, as a share of GDP, is so far undershooting the trend in previous crises. But as the authors point out, the build-up in private debt across the Atlantic this time would make the comparison notably less favourable.

Despite the clear parallels with crises past, Reinhart and Rogoff concede that the evidence is not conclusive. "Despite many superficial similarities to a typical crisis country," they write, "(the United States) may yet suffer a growth lapse comparable only to the mildest cases."

The Federal Reserve is certainly doing all it can to ensure that is what happens, by slashing US interest rates. But what about the impact over here?

The Chancellor, Alistair Darling, claims there are three reasons to be more cheerful. First, the UK is the only G7 economy to grow continuously throughout the past decade.

Second, our housing market is less exposed to any downturn because lending here has been more responsible and demand for houses still outstrips supply.

And, third, our economy still offers one of the most flexible and competitive business environments in the developed world.

That recent dynamism is, however, very heavily dependent on the continued success of the UK's financial sector and the continued buoyancy of our housing market.

And if the pressures on either or both intensify, the capacity of the Bank of England to respond already looks much more constrained than the Fed.

The latest factory gate inflation in the UK is rising at its fastest rate in 16 years. Domestic energy bills are soaring again. Food and other household staples are also on the rise.

We will find out this week what the Bank of England thinks of these inflationary pressures. But given that its sole remit - unlike the Fed's concern for both full employment and stable prices - is to keep CPI inflation as near as possible to 2%, the risks are obvious.

If UK inflation is set to push against its prescribed 3% ceiling once more, the prospects of a whole series of rate cuts here, to as low as 4%, may already be on the wane.