IT IS clear that the world's economy has turned down and many major economies are experiencing an unusually sharp period of recession in the wake of the financial shocks of the autumn.

What is not yet clear is whether this presages an extended and painful economic decline or whether the concerted responses of governments and central banks will succeed in generating a turning point during 2009.

At present, the mood tends towards the gloomier of these possibilities, but sentiment is a fallible guide to the future.

The shocks in the banking sector and the equity market crashes have had direct as well as psychological effects on economic activity, creating a mood akin to post-traumatic shock.

Individuals have reacted to an increased fear of unemployment, falls in housing and invested wealth and to tighter credit by spending less. Companies have reacted to the fall in demand, the rise in economic uncertainty and the absence of credit finance by cutting back on inventory, employment and investment. These two are starting to feed on each other and risk creating a deep and prolonged recession.

The shortage of credit is beginning to be addressed. Banks have raised a total of nearly $1,000bn in new capital, much of it underwritten by governments. This has replaced lending losses and strengthened balance sheets. However, the high cost of government capital injections has led banks to cut back on lending, in the hope of repaying the expensive capital early. This has been compounded by the uncertain economic outlook, with its threat of further bad debts from business and individual borrowers, which has reinforced the banks' reluctance to lend.

So, although cuts in interest rates are filtering through to borrowers, there is a drought in the new lending markets. On top of lower interest rates and capital injections, the Bank of England and other central banks are likely to have to offer targeted support for new lending (while ensuring banks retain sufficient risk to be prudent) and for trade finance, both of which are essential parts of the world economy.

Although there are genuine structural issues underlying the recent financial crisis, an orderly resolution of these is being prevented by the defensive reactions to the bewildering volatility in financial markets. Faced with an uncertain future, it can make individual sense to save more, cut investment or withhold lending but practised collectively, the result is economic meltdown.

A necessary benign rebalancing of the world economy (allowing western economies to reduce debt and developing economies to grow at a less inflationary pace) has turned malignant owing to the general collapse in confidence.

When confidence evaporates as comprehensively as it has, the overriding priority is to restore it, hence the recent exceptional measures to boost government spending, cut taxes and pare interest rates close to zero. Once confidence is back, policies can focus on enabling the necessary adjustments in global economies to occur in a less disruptive way.

It would be a mistake not to take steps now to ensure a restoration of confidence (but we must remember to adjust policy settings when the recession is over). Economically, we need a live goose that can lay golden eggs, not a dead parrot. To paraphrase St. Augustine "Lord make me thrifty but not yet". Have a Happy Christmas and may 2009 bring brighter times.

FOR more information, contact Rensburg Sheppards on 0151 227 2030.

Andrew Bell,

Head of Research