Recession Britain: Just how bad is it ... and will it get much worse?

As Bad as yesterday's news was, most economists expect worse; another year or more when the economy shrinks. It could easily be grimmer than we consider possible even now. After all, most of the surprises so far have been unwelcome ones. The extent of the banking crisis shocked even the most well informed insiders. Mervyn King, the Governor of the Bank of England, called it "an extraordinary, almost unimaginable, sequence of events".

At the start of this year, let us recall, almost all the forecasts were for 2008 to be a year of modest growth and flat house prices. We now know different. This year will be the first since 1991 when the economy contracts. The most recent estimate for next year from the National Institute for Economic and Social Research, an independent think-tank with an excellent record of prediction, puts the decline at a further 0.9 per cent during 2009. Unemployment will reach two million by the end of this year and perhaps three million by the end of 2010. Even the departure of so many migrant workers back toeastern Europe won't be sufficient to stem the rise in joblessness.

For those with long memories, the comparisons are only partially comforting. In 1990 to 1992, the economy shrank by a cumulative total of 2.6 per cent. Between 1979 and 1981, still the most painful episode since the Second World War, it slumped by a total of 6.3 per cent. The recession of 2008 to 2010 may not be as bad – but there is a chance it will.

Let's look at the worst case scenarios. There are three large dangers here. First, that the banks continue to suffer losses they are ill-equipped to cope with. Like a sick patient just recovering from flu before being hit by TB, they have scarcely got over their sub-prime trauma before the more routine losses associated with an economic downturn – bad debts – hit them in the solar plexus. Much of the renewed turmoil on the markets yesterday reflected that. The worry is that even the trillions of taxpayer pounds, euros and dollars now being pushed the banks way will not end the credit crunch. Mr King may have to move from scenarios that were "almost unimaginable" to the unthinkable.

The second danger is deflation. The lesson of the world economy in the 1930s, and of the Japanese post-bubble stagnation of the past 20 years, is that it is extremely difficult to reverse a situation where prices – in the shops and of houses and shares – routinely fall. This is both a symptom and cause of an economy where confidence has virtually collapsed along with the banks. If the cash you keep under the mattress is going to be worth more next year than this, why spend it?

The third danger is simply that the recession drags on, and the economy stagnates for a long time – the so-called "L-shaped" recession. In this case, the Bank of England could be prevented from cutting interest rates radically because of a collapse in the pound, already under way and possibly set to accelerate, with a commensurate danger of inflation. The Treasury, too, may be constrained from borrowing more by concerns for sterling. Thus, the British economy becomes trapped in the sort of policy bind that has bedevilled most governments since the war, and a long period of adjustment and stagnation results.

And what does all this mean for living standards? Obviously, these will be lower overall. But even in the worst depressions, most people still had jobs and life went on. The crucial element will be the extent and pattern of unemployment.

For those in the public sector, with usually generous pensions and more job security, things could even be quite comfortable. If you have a new or newish large "tracker" mortgage linked to the Bank of England rate then the big cuts in rates we might still see next year – down to maybe 2.5 per cent from their 4.5 per cent level today – will deliver a substantial rise in disposable income.

In the 1980s slump, the North suffered; in the 1990s downturn, the Home Counties; this time, the misery may be more evenly spread geographically and the winners and losers may seem almost randomly selected. It will probably be the most "white collar" recession in history. As it has to from time to time, capitalism will again prove what a capricious system it is.

The last time the economy shrank...

on 8 November, 1990

*The Righteous Brothers sat atop the UK Singles Chart with "Unchained Melody".

*Judge Dobry ended the five-year "marriage" of two men, Ian Franklin and Harley Jones. Despite a sex-change operation, Mr Jones remained a man in the eyes of the law, rendering the union null.

*Margaret Thatcher had exactly two weeks left as prime minister.

*The owner of the Daily Mirror, Robert Maxwell, wanted to sack his political editor, Alastair Campbell. The editor persuaded him not to.

Ken Clarke Former chancellor

"Anyone claiming to know for sure how bad things will get, or how long it will all last, is an idiot. The consensus, however, is that the [downturn] will be prolonged, probably sticking around until at least the end of next year. There is little that can be done immediately to soften the blow and this will likely lead to a drop in consumer spending, which will in turn lead to an increase in unemployment. The problem for the Government is that because of the state of the public finances, it has limited tools for the job. A cut in taxes might be appropriate, but this could store up problems for later on in the recession."

Angela Knight British Bankers' Association

"No one has the answer. There are some really mixed feelings, and one of those is panic. While the slowdown has been coming for months, it has really accelerated over the past few weeks. There is nothing like the sight of markets falling, currency losing value and banks collapsing to make you feel gloomy. This feeling has been exacerbated by24-hour news. And of course it is happening worldwide. Many of us have been through recession before and there are three points that will be similar. The first is that it is incredibly uncomfortable. The second is that life does carry on, and the third is that we will come out of it."

Richard Lambert Director general, CBI

"The Government measures to support the banking system have shown themselves to be very necessary. Without them, we would be in a far worse position. We must now focus on the policies that will take us forward to recovery. Today's numbers support the view that the pace of inflation will fall rapidly. Business needs a further 0.5 percentage point cut in interest rates soon. Any plans adding to the cost of employment must be delayed to protect jobs. We must also find ways to stop small firms that are otherwise sound from being pushed over the brink, and to give people more money in their pocket."

Vicky Redwood Capital Economics

"We've had to revise our original predictions that the recession would be similar to that in the early 90s. The latest data leads us to believe it could well be even worse. We think that output could fall by 1.5 per cent in the coming year and unemployment will soar to levels of the last downturn. This means that about three million people could be out of work by the end of 2010. Already confidence has plummeted – which will continue – and job insecurity is creeping up. House prices could fall by 35 per cent. Next year will probably be the most painful, but there will still be contraction in the economy during 2010."

Derek Simpson Joint secretary general, Unite

"We haven't seen the full effect of the economic downturn yet, and we don't know how long it willlast or how painful it will be. A recession will really hit businesses in the UK and jobs – which is obviously a huge concern for us. Economists are saying the downturn will be not be quick, with predictions of hundreds of thousands of job losses. I just hope that that is overly pessimistic. We hope the Government will follow through on its plans for public spending to get things moving again. It could also introduce a price policy on gas and electricity. Prices went up with the price of oil, why are they now not falling?"