Outlook: It's crunch time for liquidity

RECESSION, DEFLATION, even depression and slump - these are the words on everyone's lips. This is understandable enough: when stock markets are plunging, it's all too easy to get caught up in the rhetoric of meltdown, panic and crash.

The truth of the matter is, however, that we are not yet in a recession, nor, on the balance of probability, does it appear likely there is going to be one, either in Europe or the US. Recession is defined as two successive quarters of negative growth, and hardly anyone is predicting that for Europe and the US, even after the traumas of the last month.

That does not mean it won't happen, or that things aren't going to be anything but extremely tough over the next few years. Right now events are alarming enough to suggest a number of very ugly outcomes, each of them capable of tipping the world into outright recession.

The most compelling of these is the possibility that the bear market we are now witnessing on Wall Street will turn into something similar to the Tokyo rout of the early 1990s. Japan is the nightmare precedent for what happens when a big asset price bubble bursts. Don't try and call the bottom, just sell into the rallies and stick your money in bonds, is the doomsday lesson of the Tokyo collapse.

The parallels with Wall Street are uncanny. Like Japan, valuations were driven sky high by the belief that the US had discovered economic nirvana, that strong, low-inflation growth could go on for ever. Like Japan, the bull market in equities has itself helped sustain US economic growth by making Americans feel richer and thereby encouraging them to spend more. In Japan in the late 1980s companies thought themselves so overweight in capital that they bought stakes in one another. In the US in the late 1990s, companies buy shares in themselves.

Despite these alarming similarities, there are also some key differences. The most important of these is that as far as we know, Western banks are not up to their necks in dodgy and unsuspected property loans of the type that sank the Japanese banking system. Russian and other bad-debt problems are mounting, but on the whole Western banks appear well capitalised enough to withstand a very considerable shock without going under.

We know this, because unlike their Japanese counterparts in the late 1980s, Western banks have reasonably transparent accounts. Furthermore, the US and European economies are much more flexible than that of Japan and are therefore capable of adapting quite quickly to changed circumstances.

None of this means we should all breathe a sigh of relief and plunge back into equities. As Martin Taylor, chief executive of Barclays, argues, we may, after the latest traumatic events in Russia, be looking at a considerable, worldwide credit crunch. If nobody will lend, economic activity dries up.

So, although we may not be heading for outright recession, we've probably got two or three very rocky years ahead of us. As a consequence, the fall on Wall Street could have a good deal further to go, notwithstanding its numerous attempts at a rally yesterday. The downswing may not be as deep or prolonged as Tokyo, and its consequences are unlikely to be as cataclysmic, but when a liquidity bubble deflates, the effects are always bad. It's just a question of degree.