Hamish McRae: The real problem isn't the banking crisis

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It is time to stand back. There is too much churning around on the economic front at the moment, too much noise and not enough thought. The plight of Northern Rock is being bundled up with the problems of the global money markets; the threat of a UK housing crash with the dangers of a US recession; the performance of the UK economy with what is happening to the Government's own finances. The fact that the Government is on the ropes adds to the confusion, for it is being attacked on issues where opponents can score cheap points rather than for its longer-term errors of judgement.

So, think forward six months. Come the summer, what will be the big issues in the world economy? They won't be Northern Rock or the liquidity problems, for, one way or another, both will be fixed. But we will be quite concerned about our housing market, the US and UK economies and our public finances.

The key point about Northern Rock is that there will be an outcome within the next six weeks. An outcome is different from a solution, and every day that passes reduces the chances of it having much of a viable future. But it is, in world terms, quite a small bank. You hear huge sums being cited as the scale of government loans to it, but these are basically secured against ordinary people's mortgages. There will be a rise in bad debts over the next two to three years, but most of the taxpayers' money, maybe all, is safe. I don't know what the eventual outcome will be, though my instinct favours nationalisation as the least bad option: take it over, clean up its loan book, stick in decent management and hope to sell it at a profit in three or four years' time.

But whatever happens, while in political and regional terms it may be a big deal, in national financial terms it is not. We are lucky, in a way, that the weaknesses in our new banking regulation system showed up in a smallish bank rather than a big one. Of course we have to make some changes to financial regulation, but that can be done in a measured manner during the coming months. Since finding Northern Rock a home, or, more accurately, sheltered accommodation, has to be done fast, that issue will be settled more swiftly.

Restoring confidence to the world's money markets will take several months, but by the middle of next year they should be functioning reasonably well again. The problem is that, thanks to their own mismanagement, banks don't trust each other. So they won't lend money to each other on the money markets. Those that have lots of spare cash hoard it; those that are tight scramble desperately to borrow enough money to balance their books. As Mervyn King, governor of the Bank of England, told the Select Committee yesterday, come February or March the banks will have to reveal their full financial position in their accounts and face the consequences. Once that happens, the markets will gradually recover their confidence.

Meanwhile, the central banks have no option but to pile money into the markets. This is a global problem. Yesterday, in the space of a few minutes, the European Central Bank put 250bn into the market, yes 250bn, which even in central banking terms is big biscuits.

This is a classic, text-book liquidity crisis case, the sort of stuff that I was taught in my undergraduate money, credit and banking course in Dublin all those years ago. Banks make their money by lending long and borrowing short. It is a confidence trick: they lend money they have not immediately got available. Most of the time the trick works but just occasionally, about every 30 years or so, it doesn't, and when that happens the central banks have to lend without limit.

It has taken them a bit of time to remember their banking history, but they should know that the costs of not supporting the market swiftly have always been far greater than supporting it. They can take comfort from the fact that the central banks always win, because they have the power to create money without limit. I know some bankers are running around squealing that the central banks have not done enough, and I don't think the performance of the Federal Reserve, the European Central Bank and the Bank of England has been optimal. But, by the summer, calm will be restored.

That does not mean that it will be business as usual for the banking industry. The central banks will have to pull back the funds they have pumped into the markets, and commercial banks worldwide will be much more cautious. That will be no bad thing. You do not want, to take a familiar example, banks lending 110 per cent on a property to someone who cannot afford to pay the interest, let alone repay the sum borrowed. That situation was not sustainable. On the other hand, you do not want credit-worthy companies, or home-buyers for that matter, to be unable to borrow. The obvious question is whether the credit squeeze will tip the US, and as a result to some extent the rest of the world, into a recession.

By the summer, the situation in the US will be much clearer. The housing market there is under huge pressure, and it is not going back to normal for a long time. But we will have a much better feeling whether the inevitable slowdown transforms itself into something worse and I suppose the present guesses that it is about evens whether the US will experience recession are about right. Recession, however, is defined as two successive quarters of negative growth. So it is quite plausible that there will be a recession, but for the year as a whole there will still be some growth.

Here, things are somewhat different. We are not America. Our housing market is not in quite as bad a mess as in the US and our consumers not quite so over-borrowed. In 2007, the UK has probably grown at 3.1 per cent, which would be the fourth best year for growth since 1997. That momentum will carry us through the spring and beyond, and hardly anyone has predicted actual recession for the UK next year. Anything is possible, but growth of somewhere between 1 and 2 per cent, probably closer to 2 per cent, is much more likely.

Growth will indeed be a worry next year, but the even greater concern will be inflation and public finances. Inflation on the consumer price index is only 2.1 per cent, but that does not fool anyone. The retail price index is up 4.3 per cent, and that will square with people's experience. It is the RPI that is used for government social security payments, pensions and the interest on index-linked gilts.

As for public finances, we get the latest update tomorrow, but if the deficit is running at around 40bn, considerably above the original target, with 3.1 per cent growth, it is going to be a lot higher next year if growth is, say 1.8 per cent. Those are where the real concerns will increasingly lie; not with Northern Rock or the money markets.