Hamish McRae: Once horror story is over, we must focus on the real economy

Yes, but what about the economy? There is so much confusion about the state of the banking industry that it is hard to stand back and recognise that finance only exists as a servant to the wider economy. Obviously a lot of damage has been done to the various national economies already and there is much more to come. So you could say that until we know the scale and duration of the banking troubles, we cannot assess the damage to the economy.

Well that is partly right. Were, say, Lloyds to walk away from the HBOS deal and HBOS be allowed to go to the wall, we would have a profound slump. No government could survive, which is, of course, why governments make an implicit guarantee for the deposits of all major banks. That guarantee has been made explicit in the case of Ireland and may be made explicit here. The official position that only the first £50,000 is guaranteed is a nonsense. Why should the government have to take on that responsibility? Because we pay 40 per cent of our GDP every year so that it can bear collective responsibilities of that nature.

But if you accept (a) that no major bank will be allowed to go to the wall and (b) that credit will remain restricted for an indeterminate period, there some things that can sensibly be said about the economic outlook. Let's focus on the UK because that is, for most of us, the prime concern.

The best templates are the recessions of the 1970s, early 1980s, and early 1990s. Some excellent work by Simon Ward, of New Star Asset Management, puts what seems to be happening now in that context. He has constructed the recession indicator (shown in the main graph) from money supply measures and the corporate liquidity ratio, the ideas being to give an early warning of what might happen to the economy about nine months ahead. It also takes into account the pressure on interbank interest rates and credit spreads.

The model now suggests a 55 per cent chance of an annual fall in GDP by the second quarter of 2009. So the probability of recession is odds-on, but only just, and a long way from the 80 per cent probability ahead of the three previous recessions. The model at present predicts an annual fall in GDP of 0.2 per cent in the second quarter of next year, which he points out implies a stagnant or mildly declining economy rather than a full-blown recession.

Why should our experience this time be better than in previous downturns? Mainly because interest rates have gone up by a much smaller amount and there has been a sharp fall in the exchange rate. Think back to the early 1990s. The hit the housing market took then does look similar to the blow it is taking now but interest rates are half the level and the fall in sterling has come two years earlier in the cycle. If you look at the comparison with the early 1990s in the next graph you can see that we have not had the runaway boom conditions of the late 1980s, when real growth nearly reached 6 per cent and nominal growth was double that. Yes there was a Brown boom but not on the scale of the Lawson one.

Further support for this relatively sanguine view comes from the latest GDP data. You may recall that the original figures for growth in the second quarter came in at 0.2 per cent growth. This was revised down to zero in the second estimates, though not a negative unlike Germany, France and Italy. The latest figures confirm the zero but this is partly the result of falling North Sea oil and gas production. The on-shore economy actually inched up 0.2 per cent. It may well fall this quarter – I would be surprised if it didn't, given the gloomy manufacturing data out yesterday – but the economy as of this moment is not falling off a cliff. It may do next year, but that outcome is not yet evident.

You have then to ask what might go wrong. I can see two main candidates. One is that the present world banking chaos is allowed to continue and there is a prolonged world slump as a result. Frankly there is not much we can do if that happens but I don't think it will. It would require a higher level of incompetence from global leaders than I think they possess.

The other is if British consumers go on strike. You have to remember that consumption is two-thirds of GDP so any big swing in that has an enormous impact on the economy. Rising exports helps support demand in the long term and given our current account deficit they have to come up. But since exports are much smaller than consumption this does not help hugely in the short-run. Consumer confidence, unsurprisingly, is very weak. People have been told that the economy is going to hell in a hand cart so some at least will tend to believe that this might happen. Barclays Capital has plotted consumer confidence and retail sales together (next graph) and, as you can see, if the relationship between the two that held in the early 1990s is repeated now, we will get an absolute collapse of retail sales in the coming months.

In the medium term we will, as a country, have to consume a slightly smaller proportion of our output, shifting more resources to exports. We will also have to rebuild personal savings. The latest figures of these are most disturbing (bottom graph), for they show that household savings have gone negative for the first time for half a century. That cannot be sustained. But though savings will have to be rebuilt that ideally should be done over several years, rather than people suddenly bringing down the clamp on all non-essential spending.

Quite how you engineer a gradual and sensible rebuilding of savings, rather than a sudden and destructive one, I don't know. Politicians are powerless here. Bankers however do have influence – or rather collectively the banking system has influence – and if the banks now start recalling credit cards and slashing overdraft limits, then people will indeed be forced into a radical rethink of their spending.

My guess is that from now on there will indeed be a change of mood throughout the land. We know the Treasury is desperately seeing what it can cut from public spending and how it can squeeze up tax receipts so austerity has hit there. Most companies are reviewing their investment plans, pushing back all inessential spending. But for individuals the picture so far is more mixed. Though confidence is dire and sales of big-ticket items such as cars are weak, actually day-to-day spending does not seem to have come off that much. But there is a clear risk. We need some cuts in interest rates PDQ and I would not be surprised of the first one came next week.

All this emphasises how important it is that the banking system gets functioning again. The horror story will not carry on that much longer, for all previous experience of banking crashes shows that they have a natural cycle and this feels like the moment of catharsis. Once the turning point is clearly past, the focus will shift to the real economy and not a moment too soon.

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