When the banks get worried, politicians start to panic

"WORLD ECONOMIC crisis" - the phrase has suddenly moved into our newspapers and television bulletins. Until last month those words hardly ever appeared - I did a quick check on the main newspapers here, and all but three references in the two years prior to September were referring to 1929. Now the phrase is coming up several times a day. What has changed?

I'll tell you - bankers around the world have suddenly become very frightened. That fear is being transmitted to the various finance ministries, where the politicians who have basked in the reflected glory of economic success suddenly realise that they may have to carry the can for economic failure.

You could feel this fear in at the Washington meetings of the International Monetary Fund and World Bank earlier this week. The various finance ministers - including our own Gordon Brown - were all trotting out plans to shore up the world economy, but not agreeing on anything, except that the world needed firm action. The firm action was not coming from them, oh no!, but from the central bankers, who were being openly pushed by the finance ministers to cut interest rates. If the Bank of England's monetary committee, which makes its rate decision today, feels bounced by Mr Brown, it can take comfort from the fact that it is in good company: every central bank is under similar pressure.

But why the sudden change of mood? Why has Mr Brown suddenly realised that his growth forecast of three months ago is out of the window, when it was obvious to the rest of us that he was being dangerously over-optimistic? We all knew then that nearly one-third of the world economy was in recession, so there is nothing new in that. What is new is the fear among the bankers.

A little story illustrates the way in which frightened bankers can mess up the economy. A couple of weeks ago, a British hotel group went to three international banks for a loan to finance the purchase of another hotel. It wasn't, by commercial standards, a big deal - low millions - or a complicated one. All three banks said yes, great idea, love to do the deal, no problem. Three days later, when the company had sorted out the details, it went back to the banks. Not one of them would lend the money. There were the usual excuses, but they added up to the same thing. Head office had told them to freeze everything: just say no.

This is what is called a credit crunch. It happens when banks become frightened and refuse to lend money to anyone, however creditworthy, because they are worried about the security of their existing loan-book. It is not an interest rate problem; whatever the interest rate they would still refuse. Nor is it to do with the soundness of the customer. The problem is that the banks have to back up any new loan by ascribing some capital to that loan. They have lost so much money on dud loans, or loans that they fear may be dud, that until they have sorted themselves out they cannot risk allocating capital to new business.

The market value of many banks has halved in six weeks. So suddenly, people who thought they were running a $20bn bank find they are running a $10bn one. So, by their own market standards, they have failed.

If the banking system gums up, the economy gums up. In the instance noted above, I understand that the company will go ahead and buy the hotel, using other resources. But it is going to have watch its cash closely and be very cautious about the way it runs the whole business.

It has been clear for about a month that just such a credit crunch is occurring in the US. In Japan there has been a credit crunch for the best part of a year. On Monday Eddie George, Governor of the Bank of England, was asked about the danger of a similar crunch in the UK. He said that the Bank had not seen much evidence of it yet. Eddie - I think you may find that the Bank's early warning system is not as finely tuned as it used to be.

Today, thanks to Gordon Brown's heavy hints that the Bank should cut interest rates, there is a widespread expectation of a fall. These hints are probably counter-productive, not so much because the monetary committee will be cussed, and stand on its independence, but because the noise that Mr Brown and his team have created raises expectations that the committee will find it hard to meet. While it is politically useful to be able to shuffle the blame for an economic slow-down to the Bank, Mr Brown's attempt to do so shows his inexperience.

Whatever happens today, interest rates will undoubtedly come down in the coming months. But the decline may have less effect in boosting the economy if it is seen to be a result of political pressure. Remember that the Bank controls only very short-term interest rates; if it pushes these down too fast to be credible to the markets, long-term rates will go up. One of the unsung achievements of our monetary policy has been to cut long-term bond rates, so that the Government can now borrow more cheaply.

There is a real danger here. Many people seem to assume, here and in the US, that cutting interest rates is the way to avoid world recession. Politicians everywhere are fostering this view by calling for rate cuts. But look at Japan. They have cut rates, with the equivalent of our Minimum Lending Rate now at 0.25 per cent. You can't go much lower than that. But the economy carries on down, with sales falling each month and people becoming more and more frightened. People don't want to borrow, and banks don't want to lend.

We are not in anything like that situation here. We have sound banks. You may think they have been pretty dopey to lose money by lending it to Russia, but in general they have been less dopey than many of their Continental and US counterparts. National control of our monetary policy is not about to be handed over to a brand-new, untried European Central Bank. Most valuable of all, we have recent experience of a nasty recession, from which we have staged a solid recovery. We know house prices can go down as well as up. We are well prepared both structurally and psychologically.

There is, as yet, no "world economic crisis". When politicians say there is, they are talking rubbish. There is a very severe regional economic crisis. If the politicians mishandle things they could succeed in turning it into a world-wide crisis. There is going to be a global slow-down, but the ability of different economies to pull through will depend on how flexibly they respond.

Message to Mr Brown: you inherited a pretty good economy. Don't muck it up.