Hamish McRae: The markets have been shaken but they won't be shattered

There is, inevitably, a serious danger that the terrorist attack on the United States will trigger a world-wide recession.

There is, inevitably, a serious danger that the terrorist attack on the United States will trigger a world-wide recession. Even if recession is averted, as it may still be, recovery from the present downswing is likely to be more muted than had previously been expected.

There is really no guide to the way the world economy might react, but it is evident that the tragedy has happened at a particularly sensitive time. The US economy was already slowing, creeping forward at an annual rate of only 0.2 per cent during the second quarter of the year. The main engine of growth, US consumer spending was beginning to slow; unemployment was rising and figures released on Thursday (but referring of course to the period before the attack) showed a sharp fall in consumer confidence.

So what will happen to confidence now? Though no one can possibly know the magnitude of the likely fall, it is virtually inconceivable that confidence will not decline. Specific industries such as transport and hotels will suffer, and others such as luxury goods and entertainment seem likely to. While there will be some offsets – greater spending on security for example – on balance there will be some fall. It was possible that output would have shrunk in the third quarter; now it seems very likely.

The economic consequences of the US slowdown were already being felt around the world. Some economies in Asia, such as Singapore, were already in serious recession. Japan was almost certainly heading into recession, though the figures do not yet confirm this. Here in Europe the Italian economy had started to shrink; Germany's was stagnant. True, the impact on domestic demand in Asia and Europe may be more muted than in the US, but there must be some effect. In any case weak imports into the US reverberate around the world.

Can these negative pressures be offset by cuts in interest rates? Last week the European Central Bank decided not to cut rates but the US Federal Reserve is expected to do so soon, maybe as early as tomorrow when the New York markets open fully. The New York markets may in the short-run prove much more resilient in the face of catastrophe than many might expect, particularly if they are spurred by interest-rate cuts. The dollar, too, may retain its strength in recent weeks against the euro and the yen.

The greater the ability of the markets to function more or less as normal, the more positive the mood will be. The point here is that, from a purely practical point of view, trading will be very difficult. Many people will be not be operating from their own offices; and so, sadly, many will not be operating at all. The disaster-recovery systems put in place by all the financial institutions, whereby all deals are backed up on parallel computers, should mean that records of past transactions are available even when offices are destroyed. So some sort of normality will be achieved. The global market system will not be crippled. New York will be back in business.

But the immediate market reaction is much less important than market performance over the next three to six months. The task of financial markets is to peer into the future, in this case trying to catch a glimpse of the time and scale of the recovery. If, after reflection, they see no sign, then there is a danger that a further fall in share prices, and maybe the dollar, will make recovery harder.

Falling markets are both a sign of a lack of confidence and a cause of it. People feel poorer, spend less and demand falls. Companies react to that, lay off staff, and add further impetus to the downturn. Eventually the economy heals itself and recovery begins. But that may take some time.

If the US economy's recovery is delayed, that will have a profound impact on the rest of the world, including Britain. Much of East Asia is particularly dependent on exports to the US; in Europe, Germany in particular has also been dependent on exports to sustain demand. Britain might seem to be less vulnerable, since, despite the difficulties of the manufacturing sector, domestic demand has been quite strong.

Prior to the catastrophe, growth forecasts for both the US and the eurozone had been revised down. Indeed the consensus of forecasters was that the UK would this year grow faster than either the US or the rest of Europe, and of course much faster than Japan.

So it remains possible, despite the close links between the US and British economies, that the UK will still escape recession. But like the rest of the world, there will almost certainly be a period of rather slower growth here for some time to come.