The New Nation - Internet Edition

Larry Elliott

It's the spring of 2009 and finance ministers from the G7 are once again gathered in Washington for the half-yearly meeting of the International Monetary Fund. After grim 2008 the economic skies are clearing. Growth has started to pick up; property prices have stabilised; financial markets sense better times ahead.

A year earlier the IMF described the crisis that erupted in August 2007 as the most profound shock to the global financial system since the Great Depression. Fortunately, however, the economic fallout from the losses made on sub-prime mortgage loans proved to be far less severe than the slump of the 1930s. There are sighs of relief all around at disaster narrowly averted.

This is the sort of outcome that the IMF and the G7 expect; a short-lived recession in the US; a period of sluggish sub-par growth for other developed countries; a modest slowdonw in the performance of the leading developing countries.

The reason for this confidence is that the policy response to the crisis will prove more effective than the botched handling of the Wall Street crash. Contral banks have cut interest rates and pumped cash into the banking system. In the US an easing of monetary policy will shortly be accompanied by a $150bn tax cut.

Some economists-including the former US treasury secretary Larry Summers- believe that the bailout of Bear Steams last month will prove to be a cathartic moment. Once the Federal Reserve made it clear that it was prepared to do whatever it took to prevent leading. Wall Street institutions from collapsing sentiment staried to improve.

Should Summers be proved right, there is indeed, a possibility of a relatively soft landing for the global economy. The return of a modicum of stability to credit markets will be

followed by a pick-up in activity as the pro-growth policy markets start to feed through into stronger consumer and business confidence.

There are problems with this thesis, however. The first is that it is far too early to say that the worst is over, Henry Paulson, who does Summer's old job at the US treasury said he expected to see some impact from lower interest rates and tax cuts by the third quarter of this year. But that depends on the US housing market stabilising, because until it does there is a real risk of a vicious circle of foreclosures, collapsing consumer confidence, rising unemployment, bigger losses for US banks, tighter credit conditions and a falling stock market.

The IMF says that risks are still heavily weighted to the downside. It produced an alternative scenario in which there would be a further tighening of credit conditions, a far bigger drop in equity and property prices than it currently expects, a gloomier assessment of the prospects for long term productivity growth in the US, and an unwillingness on the part of foreign investors to continue buying US assets.

It already believes there is a 25% risk of a global recession; under this alternative scenario, it says there would be a deeper and longer period of falling growth in the US, accompanied by an extended period of weakness in the eurozone and spillover effects on the rest of the global economy through weaker trade flows and tougher credit conditions. This scenario looks just as realistic as the fund's baseline soft-landing forecast. For one thing, there is a clear disjunction between the idea that this is the biggest financial shock since the Depression and the idea that there will be only a short-lived and realtively mid impact on growth.

In addition, the soft-landing thesis conveniently ignores the other headwinds facing the global economy. These include rocketing commodity prices that are contributing to a sharp rise in imported inflation, severe downward pressure on the dollar that threatens toi become a disorderly plunge, the still sizeable global imbalances that have resulted in massive trade surpluses in Asia, and massive trade deficits in the US, which have been only slightly reduced by a cheaper greenback and weaker growth.

That list was supplemented last week by global hunger caused by rising food prices. The world has suddenly woken up to what should have been blindingly obvious; trying to solve the problem of climate change by using crops for biofuel was a short-term fix with potentially lethal result. If you encourage farmers to use land that would have produced food for fuel, the price of food will go up.

Gordon Brown considers this to be a serious crisis and is right to call for a global response. Yet apart from the humanitarian need to help those going hungry, rising food prices make it harder to avoid recession in the West, since they stifle consumer cinfidence and make policy-makers warier about cutting interest rates.

All in all, it would be little short of miraculous were the global economy to escape from the pricking of a colossal credit bubble with a slowdown that the fund is expecting to be far less severe than those in the mid-1970s, the early 1980s or the early 1990s. Indeed, the IMF says that the slowdown will be the mildest in the post-war era apart from that in 2001.

The history of the past 400 years suggests that bubbles develop no matter what safeguards are put in place by policy makers. But that does not mean that they should not try.