Don't be fooled: the outlook remains gloomy

The worrying aspects of the world economy will continue to depress markets once the shooting is over

You could say that the world of finance prefers war to uncertainty. Quite suddenly, the markets have calmed themselves. Shares have risen sharply from their lows of last week. The dollar is at a two-month high against the euro. The oil price is falling back from its peak. Most important of all, there are now suggestions that last week saw the bottom of this bear market, already the longest and deepest for three decades.

You could say that the world of finance prefers war to uncertainty. Quite suddenly, the markets have calmed themselves. Shares have risen sharply from their lows of last week. The dollar is at a two-month high against the euro. The oil price is falling back from its peak. Most important of all, there are now suggestions that last week saw the bottom of this bear market, already the longest and deepest for three decades.

But of course huge uncertainties remain. One question: "Will there be a war?" has been replaced by another: "Will this conflict be swift and successful?"

The markets' implicit answer to this second question would seem to be "yes". But, of course, markets have been known to get things wrong. Many of the underlying problems of the world economy in the aftermath of the late 1990s "bubble" have still to be resolved. The difficulty is to distinguish to what extent the markets have been signalling their specific concern about the Middle East and to what extent they have been fretting about more general worries about the growth and stability of the world economy.

Looking forward, there will be a sequence of decision points and events that will tell us whether a corner has been turned. In the short term, these will naturally be war-related; in the longer-term, the issues will be those that were causing alarm before it became clear that war in the Middle East was inevitable.

First will be the duration and success of the conflict. The world's markets are making two assumptions. The first is that the "hot" aspects of war will be over in a month, six weeks at most. The second is that there will be a large measure of political success associated with the fighting.

For example, they assume that the allied forces will be generally welcomed, for without that a long, difficult, and perhaps impossible policing operation would be needed. They assume, too, that neighbouring regimes, particularly Saudi Arabia, will not be destabilised by anti-American sentiment. And, since they are assuming that the war will be short, they are estimating that the financial burden on the allies will be manageable.

The markets assume, too, that the oil market will cope. In the very short term it will, because part of the strategic reserve can be released – rather like another huge oilfield coming on stream. People point also to the precedent of the Gulf War, when the price spiked up to $40 (£25) a barrel but then quickly fell back again. However, the underlying supply/demand situation is tighter now and the rise in the oil price is already squeezing the incomes of consumers in the United States. American consumption remains the only significant source of demand in the world and that source has been wobbling of late. So the world economy remains extremely vulnerable to another oil shock.

Indeed, the markets now seem to be assuming that events in the Middle East will turn out towards the more favourable end of the possible scale. Last week, they seemed to be in a funk, fearing that things would go badly. It would be naive not to admit to the possibility that their most recent cheer might be as poorly-founded as their previous despair.

Meanwhile the longer-term problems remain. In the US and UK, growth has been maintained by a surge in consumption financed by borrowing and by the move of the public sector from surplus to deficit. In much of continental Europe, consumers have held back their spending, with the result in low growth and widening deficits. In Japan the financial problems mount and the economy remains as moribund as before.

All of these worrying aspects of the world economy will continue to depress markets once the shooting is over. Given time, they will be tackled, for one of the most important lessons of economic history is that in most circumstances economies are self-healing. Given peace, security and the absence of damaging policies by governments, they eventually fix themselves. The danger is that the conflict might undermine the capacity of the world to fix itself.

And not just the conflict. There has clearly been huge damage to international relations within Europe and between some European countries and the United States. Some of that will spill over from politics into economics. The issue here is not just whether there will be a boycott of French goods in the United States or even whether international investment will shift. It is whether the broad assumption underpinning post-Second World War prosperity – that the world economy would become ever more integrated globally – still stands. It does probably still stand, but only probably; and the rifts will take some time to repair.

There is a huge amount riding on what happens during the next six weeks. War is coming just at the time when we ought to be seeing a turning point in the economic cycle. Yes, there is a huge amount of adjustment still to be done. Yes, the next two to three years were always going to be difficult. But the conflict has to be successful, so that in the short term world consumers can recover their confidence and start buying again. And it has to be successful so that in the medium-term the big economic blocs – not only the North American Free Trade Agreement and the European Union, but also Japan, China and the developing world – can keep trading and co-operating.