Stephen King: No gold medals for UK's economic performance as hopes turn to ashes

Viktor Chukarin was the first Soviet sportsman to be awarded the Order of Lenin. A gymnast who won a hatful of gold medals in the 1952 and 1956 Olympics, he was a true Soviet hero.

As the Cold War warmed up, Stalin, Kruschev and their henchmen doubtless regarded Chukarin as a great example of Soviet power. Achievements in the gymnasium, however, were not matched by economic success. Soviet Communism ultimately failed to deliver, no matter how many gold medals were won at the Olympics, and no matter how many gongs were subsequently dispensed by the Politburo. Awarding medals to sportsmen was a good way of creating a "feelgood" factor when, in reality, most comrades were feeling very bad indeed.

Funnily enough, the latest batch of honours handed out in the UK seems to be following a similar model. There can be no doubt that Chris Hoy, Rebecca Adlington and the rest of our Beijing superstars are true Olympic heroes. They've won their gold medals, they've become national celebrities and I'm sure they fully deserve their honours. The message, though, is eerily familiar. By awarding honours to sportsmen and women, we can pretend that Britain is still Great. Britain's economy, though, is a bit of a failure.

If you thought 2008 was bad, the coming year is likely to be even worse. And, unlike last year, there will be no Olympic heroes to hide the pain. We've already had an inkling of what's to come through some of the latest catastrophically awful bits of data from around the world. As a major trading nation, the UK is hugely exposed to bad news coming from elsewhere.

The US Institute of Supply Managers' monthly survey of manufacturing conditions was unbelievably bad. The overall index fell to 32.4, its lowest level since 1980 (when the US economy was embarking on the so-called "double-dip" recession). The new orders series, an important component of the overall report, plunged to its lowest level since the survey began in January 1948. Meanwhile, the pricing component of the survey points to the greatest deflationary threat in the post-war period.

On the other side of the Pacific, Japan also received some very bad news. In November, Japan's industrial production fell by 8.1 per cent from its October level. This was a remarkable contraction in just one month. It's now clear that the world's two biggest economies are both in serious trouble.

The UK is facing bigger threats than seemed likely a year ago. Back then, the main concerns were associated with a US downswing, an occasional bank failure, rapidly increasing oil prices and, as a result, a modest rise in imported inflationary pressures. Unfortunately, our economic worries now are much more deep-rooted.

First, we're no longer facing a US downswing but, instead, a global downswing. Weakness can be seen everywhere: from China to Chile, from Switzerland to South Korea and from Turkey to Thailand. At HSBC, we've been busily slashing our growth forecasts for countries all over the world. Totting the numbers up, it looks as though global output will shrink this year, an extraordinary development in the modern era. Karen Ward, our UK specialist, thinks UK output will drop 2.5 per cent in 2009.

Second, while the global downswing is partly a trade-related issue, it is mostly being driven by the spreading tentacles of the credit crunch. These seem to have an uncanny knack of reaching into any economic crack and crevice, no matter how far away they are from the world's major financial centres. Many emerging economies, for example, became increasingly dependent in recent years on inflows of loans from the Western banking system. Those flows are now drying up, as indeed are the emerging markets' economic prospects.

Third, as countries struggle to keep credit lines open, we're facing the risk of a new wave of protectionism driven not so much by trade barriers but, instead, by restrictions on capital flows. If the overall supply of credit is drying up, governments will be tempted to hoard as much international capital as they possibly can, either explicitly through the use of capital and exchange controls, or implicitly through pressure on bailed-out banks to focus on domestic lending at the expense of foreign lending.

Fourth, there's now a serious risk of debt deflation. The credit crunch has created a climate of money hoarding. Uncertainty over where the next loan is coming from has persuaded people to hang on to any money they've got: no more house buying, no more car purchases and no more investment. And, unlike last year, the Bank of England, in common with other central banks, has very little firepower left to fight deflation. Interest rates are already down to just 2 per cent. It won't be long before they're at zero. If, at the same time, prices and wages start to fall, the real (inflation-adjusted) debt burden will begin to rise. What does a central bank do next?

The lack of clarity over policy is particularly disturbing. Whether it's Bob the Builder's question ("can he fix it") or Barack Obama's answer ("yes, we can"), we're entering highly unusual territory. There will be no more interest rate cuts to look forward to. In the US, President-elect Obama is sure to launch a massive fiscal package: some estimates suggest that, over a two-year period, the stimulus will amount to an eye-popping $1trn (approaching 7 per cent of GDP). In the UK, however, the room to manoeuvre is seriously curtailed. Alistair Darling, the Chancellor, has delivered a stimulus, but it's only worth around 1 per cent of GDP, limited by the already creaking government finances.

Other options exist. The Government could choose to buy, or to guarantee the value of, securitised financial assets in the hope that banks' funding would improve, thereby increasing the supply of lending within the economy. There might be an attempt to shore up the value of the stock market, in the hope that a government-guaranteed floor would restore confidence (Hong Kong did this successfully during the Asian crisis in the late 1990s). Then, as I've argued in these pages before, there's the nuclear option of printing money and getting the Government to spend it. If there's a perceived shortage of money, the printing press is the most obvious way of shifting people's beliefs.

These options fall into the "unconventional" bracket. They're unconventional because no one can be sure about how they work. How should success or failure be judged? There are no clever mathematical models to provide the answers because these kinds of policies have not been subject to rigorous statistical testing. And, after years of trying to be as transparent as possible in the presentation of policy, the Bank of England will find itself moving back to a world of opacity. Rather than merely placing a gentle hand on the interest rate tiller from time to time, the Monetary Policy Committee will have its work cut out explaining how these peculiar policies are supposed to work. That will be no easy task.

Maybe, then, we'll simply have to rely on some great sporting victories to mask the pain. If it's not the Olympics, it will have to be the Ashes. We need another feelgood factor. Kevin Pietersen, your country needs you!

Stephen King is managing director of economics at HSBC