《每日电讯报》：2008年是难忘之年，但也是我们在很长一段时间内无法忘却的一年

It is a measure of the scale of the disaster that, in a single weekend, Lehman Brothers and WAMU (the largest bank failure by size of assets in history) went bust, and Merrill Lynch was forced to seek sanctuary with Bank of America. Prior to the Crunch, any one of these events would have been experienced maybe once in a decade.

The reason for touching upon the scale of the problems is because it has some bearing on what happens next. Clearly we are in a global recession. But how long and deep will it be?

Let's start with a few facts, focusing on the US economy, as it is still the largest economy in the world and was the epicentre of the Crunch. During the period 1945-2001, the average downturn in the US economy lasted 10 months. However, I suspect we have to take a longer term view of recessions to gauge this downturn. Why? Because it was preceded and indeed precipitated by a banking crisis.

In a normal cycle the economy turns down. This then causes bad debts for the banks who experience a fall in profits and may need to raise capital to replenish what they have lost. In 2008, the banks went bust before the economic downturn started.

The other problem which may make the recession longer and deeper than average is that the Keynesian policy responses which governments are programmed to deliver are handicapped by their prior profligacy.

The text books say that in these circumstances, governments should spend more than they raise in taxes in order to stimulate the economy. The problem is that the UK and the USA had already achieved record deficits prior to the downturn. The contrast with the last major recession in 1990-92 could hardly be starker: in the late 1980s, the Thatcher Government came close to repaying the national debt. This time, they were out of ammunition before the battle started.

I think that the downturn will be much more prolonged than usual. The average for the USA for 1854-2001 was 17 months, but the Great Depression of 1929-33 lasted 43 months and the grandaddy of recessions in this period was one which lasted 65 months from 1873-79. It would be wise to prepare for a long siege.

The government deficits also coincide with the assumption of massive financing to support the banking system with capital and liquidity and, in many cases, blanket guarantees of deposits and other bank liabilities, such as Ireland has put in place.

This is why the next battle will be over the creditworthiness of governments and the strength of currencies. We have already seen the collapse of Iceland caused by its banks having liabilities which its economy couldn't guarantee. It may be tempting to see Iceland as an isolated and extreme case, but don't be fooled. Any country and currency is at risk which has guaranteed bank liabilities which are large in relation to its total economy.

Ireland's economy flourished as a result of the growth of the financial services sector in Dublin. It is impossible for the Irish currency to come under pressure as it is in the euro and so can rely upon the support of Germany's large and relatively conservatively run economy to underwrite it.

But being in the euro does nothing for the creditworthiness of Ireland's debts and other obligations. The credit derivative market has already latched onto this and is demanding significantly higher premiums for insuring against default on Irish debt.

But before we get too complacent, we should recognise that the UK also has a serious problem, because the sterling is not linked to the euro. This pressure can already be seen in the rapid decline of sterling and the fact that it its now cheaper to insure the debt of McDonald's against default than it is that of HM Treasury.

The UK and Ireland are not alone in this. But at any of these currencies or credit ratings could go into catastrophic decline.

However, for me, the $64,000 question is not how long the recession will last or whether one or more currencies or governments' credit will be severely damaged; it is whether we will get deflation or inflation as a result of this crisis.

The immediate impact of the withdrawal of credit and the fall in asset prices and demand will be deflationary. However, some commentators suggest that while this will indeed be the initial impact, the overwhelming government response of printing money to fund and capitalise banks, and now other industries, will have an inflationary effect. In the long-run this may well be the case, but I suspect we will be living in a deflationary environment for a significant amount of time. Why? For the same reason that I believe that governments in the UK, USA and elsewhere are not in a position to substantially increase their spending: there is also the problem that policy responses are not equally effective against inflation and deflation.

To put it simply, a government can always raise interest rates until they have stifled inflation. But you cannot cut rates below zero. Japan's long deflation and recession after its asset bubble burst in the late 1980s shows how ineffective government policies can be against deflation. But one thing is clear: both inflation and deflation are pernicious, and we're definitely heading for one or the other, or maybe both in succession.

Terry Smith

The Telegraph