Comment: Admit it, Chancellor, real recession is now inevitable

There have been nine periods of decline in the past 70 years. We are coming up to the tenth

WOW! I doubt whether there has ever been a more tumultuous few days in financial markets around the world than last week.

It was as if a savage bear market, which might normally endure for 12 to 18 months, had been compressed into five sessions. The dollar collapsed, investors dumped the safest of the safe - securities issued by governments - and equities went on plunging.

So great was the panic on Thursday and Friday that many of the more aggressive operators, now in a state of shell-shock, attempted to find shelter by turning as much of their portfolios as they could into ready cash.

What this means is that the world's financial system has just suffered an unprecedented, bone-breaking, dislocating shock. We can endlessly debate the causes, but so far as the self-confidence of the suppliers of credit goes, it does not really matter whether bad loans are the result of a Russian default or a more familiar catastrophe at home.

Nor, when financial markets of all kinds suddenly take a dive, does it make it any easier on the nerves that some of the securities concerned were highly sophisticated, and were traded only between professionals.

Inevitably, the result will be that the amount of credit available to us all, whether by way of mortgages or overdrafts or hire purchase arrangements, or in the form of the loans that most companies need to supplement their capital, is going to be significantly reduced.

Economic activity will be scaled back, some individuals will get into difficulties and some companies will go bust. There will, undoubtedly, be a recession.

Please do not be misled by the Government's refusal to admit this. I don't believe any Chancellor of the Exchequer has ever pointed out the likelihood of economic setback, although there have been nine periods of declining activity in the past 70 years and we are coming up to the 10th. Ministers believe that if they speak openly about such a disagreeable prospect, they will make it even worse, quite apart from finding it politically inconvenient to do so. The most they will say is that growth will be less robust. Moreover their advisers, like all economic forecasters, work on the basis that the future will be like the past. But as there has never been a world financial crisis like the present one, they are all at sea.

I want to return to an unusual aspect of the crisis which I first mentioned two weeks ago. Every crisis since the war, except this one, has involved inflationary excess. Sharply rising prices forced the government of the day to slam on the brakes. It would then deliberately tighten credit by raising interest rates, rather than finding, as it does now, that credit is going to contract far too much anyway, and interest rates must urgently be reduced in order to avert a dangerous situation. We are touching here on a second risk - that the recession may bring about deflation, or falling consumer prices, and thus become deeper and longer-lasting than it would otherwise have been. Perhaps this is what markets have unwittingly reflected.

A general decline in the cost of everyday goods and services was last experienced in the Thirties; before then it was a regular occurrence. Boom and inflation, recession and deflation was the normal rhythm until 1939. Deflation has the same adverse impact on business activity as a tightening in credit. Spending is delayed. If prices are falling, it seems only sensible to hold back from making purchases.

Moreover, deflation is near. While price rises in the United Kingdom are still running at 2 to 3 per cent per annum, they are vanishing elsewhere. Deflation is near, I should say, so far only as a matter of statistical record. This is an important qualification. Real deflation, if I may call it that, will occur only when consumers are conscious of falling prices and change their spending habits as a result.

We have got used to the idea that the cost of electronic consumer goods tends to decline - calculators, mobile phones, personal computers and the like. However, we do not expect deflation outside these markets. We also learnt in the last recession that house prices can fall, a phenomenon we had not experienced since the war.

Again, consumers have declined to draw the conclusion that what goes for houses can be generalised. Outside electronic goods, the only area where prices have been cut in spectacular fashion has been newspapers. But here consumers seem to have thought to themselves, not without reason, that newspapers are a crazy business anyway.

Thus our main protection against "real" as opposed to "statistical" deflation, is that consumers are not yet at all disposed to believe in such a thing.

Indeed, in most people's minds, last week's dramatic storm in the financial markets was well out to sea. Sure, some boats were capsized, but who really cares about a New York hedge fund or a famous Swiss bank? What I am saying is that the tempest is heading this way. None of the forecasters know whether it will largely blow itself out before it touches our lives, or whether it will still be raging fiercely. The main precaution we can take is to prepare our minds for what may come.

Redundancies will be more common and jobs harder to obtain. The shake- out has already begun in the City and in other financial centres around the world. This will spread beyond the financial sector. As for private investors in unit trusts and individual shares, they have probably missed the moment to sell if they have not already done so. The last stage of a bear market begins when cash appears the most attractive option. Suddenly, that point has been reached.

Deflation is particularly treacherous for borrowers. Inflation, since the war, has always treated them kindly by reducing the real value of their interest payments and borrowings. That is why people used to be advised to take on the biggest mortgages for house purchase that they could arrange.

With deflation, the burden of debt and interest payments rises in real terms and becomes ever more onerous. Whether you are a government, or a company, or an individual, debt is back-breaking in a deflation. While I believe that the risk that we shall enter a real deflation is not yet great, nonetheless it is enough of a possibility for borrowers everywhere to make the reduction of debt a priority.

Until we are sure that the risk of a destabilising deflation can be avoided, let there be this financial health warning: debt is dangerous.