The week the economy turned nasty

Retail sales plummet; gas and electricity prices soar, further eating into already squeezed disposable incomes; Citigroup and Merrill Lynch, two of the great symbols of American capitalism, forced to hand round the begging bowl among Asian and Middle Eastern sovereign wealth funds after massive write-downs on US sub-prime mortgage lending.

Northern Rock teeters on the brink of nationalisation; confidence in the UK housing market drops to its lowest level since the recession of the early 1990s; share prices bludgeoned; sterling in free-fall; corporate profit warnings at a six-year high; retail investors dash to withdraw their money from collapsing commercial property funds; credit insurers downgraded, threatening multiple defaults in debt markets.

Yes, indeed. This was the week when any lingering hope that the US and UK might somehow muddle through the crisis that has engulfed the international capital markets without undue damage to the underlying economy finally seemed to evaporate.

In economics, it rarely pays to be alarmist. In the panic of a crisis, things always look grim but the long-term reality frequently turns out to be not so bad. Nobody can know the future and the book is still very much open on how these present dislocations might play out.

Can we still hope for just a mild downturn, or will it be one of the big, searing ones like those of the 1970s and early 1990s?

One thing seems certain: outright recession – with job losses, bankruptcies and home repossessions surging – looks a lot more probable this weekend than it did just seven days ago.

It is hard to recall a week of such concentrated negative economic news. Even if the underlying reality hasn't so far been that bad, these things tend to become self-fulfilling once business and consumer confidence goes in the way now threatened.

Central bankers look set to respond with further steep cuts in interest rates. Some City analysts expect the UK base rate to be cut by 100 points over the next year.

For the time being, Mervyn King, Governor of the Bank of England, must set aside his concerns about the increasingly ugly medium-term outlook for inflation and address growth instead. In the US, the risk of economic contraction is already judged to be the greater evil, and Wall Street is alive with talk of emergency interest rate cuts. Massive further injections of liquidity also look probable in an effort to cure the banking system of its sickness.

Yet those medicines haven't worked so far, and the worry is that it may already be too late to stop the economy sliding into a funk. Repeated banking bail-outs are in any case being increasingly challenged by politicians who question why bankers should be rescued when it was their bonus-driven culture – and the huge incentives it provides for the pursuit of extreme financial risk – that helped cause the crisis in the first place.

Despite the vast losses reported by investment bankers for last year, pay and bonuses remain almost untouched, with the rescue capital being provided by the sovereign wealth funds of the developing world eaten up by the excessive remuneration of these would-be "masters of the universe" almost the moment it comes in through the front door.

Politically, the economy has never looked more dangerous for Labour and the architect of its economic reforms, Gordon Brown. The Prime Minister's always exaggerated claim to have abolished boom and bust and laid the foundations for long-term stability, repeated in Prime Minister's Questions this week, has rarely seemed more hollow.

On the contrary, the Government's deliberate "light touch" approach to regulation of the City, its failure to put in place an adequate deposit insurance scheme, and the focus on narrow inflation targeting in monetary policy, may have made the economy more exposed to crisis, not less so.

Though the implosion has its origins in reckless sub-prime mortgage lending in the US, many of the wider structural problems highlighted by the consequent meltdown are mirrored and magnified here in the UK, with out-of-control house prices, excessive personal debt, and a burgeoning current account deficit.

The City has played a central role in spreading, like a virus, the problem of US mortgages into debt markets around the world, helping to invent and popularise largely unregulated financial structures and products that, far from making the banking system more stable as they were supposed to, seem only have made it less so. Worryingly, present circumstances almost exactly mirror the pre-conditions of all of the big five economic downturns of the post-war period. According to a paper published this week by Ken Rogoff, former chief economist at the International Monetary Fund, the first major financial crisis of the 21st century "follows a well-trodden path laid down by centuries of financial folly", and he finds "stunning qualitative and quantitative parallels" with virtually all the crises of the post-war period.

Common features are a steep run-up in house and other asset prices, sustained by large inflows of foreign capital of the sort we have seen in both the US and Britain over the past seven years. The other shared characteristic is a big increase in public debt, which has again been present in the build up to the present crisis.

The average for the downturns which have resulted from each of the 18 banking crises identified was a drop in real per capita output growth of more than 2 per cent. Typically, it took two years to recover to normality. In the five most serious cases, the drop in annual output growth from peak to trough was 5 per cent with growth well below normality even after three years. What would such a contraction feel like? For those who enjoy stable employment and substantial equity in their homes, it may not feel that different. But for a sizeable minority, it would be brutal.

Many will lose their jobs with little hope of finding a new one on comparable pay in the immediate future, and those who bought on 100 per cent mortgages at the top of the market will find themselves in negative equity. Even for those whose jobs survive the implosion it will not be comfortable.

As many are already finding, mortgage repayments are rising steeply despite falling interest rates as two-year fixed deals taken out when rates were abnormally low are replaced by more expensive packages.

Disposable incomes are being further squeezed by fast-rising utility and fuel bills. British Gas yesterday became the latest company to raise its prices with a 15 per cent increase in its gas and electricity bills. About the only products that are falling in price are electronics and cars.

Meanwhile, falling stock markets will impair the value of pension saving, with the result that it will take longer to accumulate the size of pension pot necessary to provide a decent income. Micro-employment, one of the strongest growing areas of the jobs market in recent years, will be hit hard as consumers cut back on personal trainers, pedicures and massages.

I'm not saying any of this depressingly gloomy prognosis will definitely happen. Even very serious financial crises can quite quickly be reversed given the right policy response, as occurred in 1998. But the present upset in credit markets has gone on for much longer than anyone thought, with still no sign of it abating.

Three of the biggest drivers of economic growth in Britain in recent years – the credit-fuelled surge in consumer spending, soaring house prices, and the booming financial services industry – have been removed and it is not immediately obvious what might replace them.

The falling pound should, in theory, make our exports more competitive, thereby providing a boost for manufacturers. Unfortunately, manufacturing is a comparatively minor part of the UK economy. The City and all the business services that feed off its largesse, has become a near-dominant part of Britain's economic output, and is quite possibly already in recession.

What's more, the economy is moving into a downturn with the public finances in some disarray. Increased public spending, which helped see the country through the last economic downturn of five or six years ago without going into negative growth, is not an option this time around. Current Treasury plans are for a severe squeeze in public spending.

The City view

Malcolm Barr, senior UK economist, J P Morgan

It's not the single most likely scenario by a long way. But there are some clear vulnerabilities which leave the UK exposed to what's happening in the US. The data in the US suggests the possibility of recession is uncomfortably high there. Of our vulnerabilities, the high level of house prices is significant, but of most concern is the fact that the level of spending in the economy looks very high relative to people's incomes.

David Owen, chief UK economist, Dresdner Kleinwort

The risk that GDP in 2008 is lower than 2007 is very small. Similarly, the chances of a recession on the scale of the early 1990s or 1980s are almost nil. But the risk of a technical recession is 50/50. The situation in the housing market is deeply problematic, with indications that the bubble is bursting. Given that market's centrality to the UK's economic health, the impact on consumer spending of a major correction could be severe.

Mathias Schumacher, managing director, Duff and Phelps

The chances of a recession are higher in the US but, given that the UK economy is closely tied to its Atlantic partner, negative effects will be felt over here, too. We can certainly expect to see a slowdown in the financial services sector. All the sectors that are heavily dependent on the US dollar exchange rate will be heavily hit, whereas those that depend more heavily on the euro will fare better.

George Buckley, chief UK economist, Deutsche Bank

We've seen a lot of numbers suggesting price pressures could be growing steadily, not least because sterling has fallen significantly since last summer, making our imports more expensive. But the biggest risk we face is that despite weaker economic growth, the Bank of England might not be able to cut interest rates by as much as they'd like to, because of inflationary concerns. This poses serious dangers.