Don't panic, we've known harder times than these

It is "if?" time. But not so much the current "iffy" questions, such as "if the stock market collapse continues will Gordon Brown's spending plans be derailed?" Or "if the US consumer stops spending what happens to the world recovery?" Or even "if the Americans make a mess of the Iraq invasion, what happens to the entire Middle East?"

No, the "if" I had in mind was Kipling's "if you can keep your head when all about you/are losing theirs ...." There is something close to panic in the world's financial markets, so it is time for some perspective. The fall in share prices is, so far, a once-in-a-generation hurricane – the sort of crash that occurs every 30 or 40 years, perhaps twice in a career or three times in a lifetime. The last two similar bear markets were in the early 1930s and the early 1970s.

The fall is global, but most serious in Japan (where the peak in share prices was two decades ago) and to a lesser extent Germany (where the main share index has halved in value). But the important points to grasp are that this is very unusual by historical standards and that the further markets decline, the more unusual it becomes.

In contrast to the mayhem in the markets, the fall in output of the main economies is, so far, only a once-in-a-decade phenomenon. We can all remember the early 1990s, when Britain had a long but not desperately deep recession. This time we seem to have managed to escape recession altogether, unlike most other large developed countries. But if you look globally this downturn is, so far again, pretty standard stuff: there was a broadly similar downturn in the early 1980s and a rather worse one in the early 1970s.

Now there are characteristics that are peculiar to this cycle: for example, the bursting of the hi-tech bubble and the collapse of pricing power in many industries. But then all cycles have their special characteristics. In the 1970s, the most serious post-war downturn, it was runaway inflation, the oil crisis and, in Britain, dreadful economic management by both parties. In the 1980s it was, in Britain, the collapse of manufacturing and serious labour unrest.

Even if there is a double-dip to the current cycle – and that looks increasingly likely – it is hard to see it being as bad as the 1970s cycle. Yet one has to acknowledge the fear in the markets and ask what might turn this once-in-a-decade global downturn into a once-in-a-generation one. (Let's not even think about the possibility of a once-in-a-century depression akin to the 1930s because that really is unlikely.)

I can see three main risks that the world economy faces – things that would create the once-in-a-generation recession. The most obvious, but perhaps least likely, is that there could be a level of disruption in the Middle East that would be much worse than that of the Gulf War. Were there to be a serious interruption to oil supplies, the oil price double to $60 a barrel and stay there for a year, that would be enough to make the second leg of the downturn steeper than the first.

A second risk is that the collapse of the financial markets will abort the recovery, as happened in the 1930s. The Japanese banks are bust, the German ones under severe pressure and insurance companies everywhere are needing injections of capital to keep going. Given that these sort of declines in share values are very rare, it would be astounding if the financial system were not under severe pressure. In a way the surprising thing is that it is coping so far. Think back to the 1970s fringe bank crisis – our financial system was in far worse shape then than it is now. Much the same can be said of most countries, with the exception of Japan. The credit for that goes both to the regulators and the financial institutions.

The US financial system is reforming itself with considerable speed. It was capital punishment for Andersen, the accounting firm that most transgressed. The Wall Street brokerage houses are responding to the justified criticism that their analysts puffed the shares of their investment banking clients while presenting their views as independent. There will be either organisational or legal changes (or both) to make sure analysts return to the path of virtuous independence.

Nevertheless, there is a risk that there is something seriously wrong in the financial system that will catch the authorities unaware. Perhaps worse, there is a danger that, as and when the economy wants to expand, the banks and securities markets will be too cautious to provide the finance to enable it to do so. The world needs careful bankers, not terrified ones.

The third risk is that one particular characteristic of this cycle will get out of control: deflation. We have moved, with some pain, from a world of very rapid inflation to one of low inflation. Now we are reaching price stability. Yes, I know that taxes and public service charges are still inflating but the price of goods is actually falling. The GDP deflator, the best measure of inflation, in the US is now rising at only 0.5 per cent, in Japan and probably Germany it is on the way down. This transition is hard to manage. We are asking people world-wide to change their entire expectations for everything from house prices to wage demands. Many people have hardly begun to cotton on to what is happening.

Amongst the potential people who will make errors are the policy-makers. The first country to make the transition, Japan, mismanaged it and, largely as a result, turned a difficult transition into a catastrophic one. Continental Europe may be making a similar mistake. An inexperienced European Central Bank has set interest rates that are almost certainly too high, focussing too closely on inflation and not noticing the longer-term dangers of deflation.

It, like the Bank of Japan, has a tricky task, though for different reasons. The Japanese problem was the scale of the bubble that had to be pricked; the ECB's is setting a one-size-fits-all interest rate for a region that needs very different rates. But both needed to err on the side of setting rates too low – and both set them too high to start with. When the Bank of Japan did cut rates almost to zero it was about a year too late.

This is not the place to criticise the euro but it is clear Europe could hardly have chosen a worse time to experiment with something so important as a new currency. As a result of the euro and the Stability and Growth Pact, both monetary and fiscal policy in nearly one-third of the world economy have been neutered. The US Federal Reserve has cut rates sharply, so maybe we will scramble through without deflation getting out of hand. But it will be a close-run thing.

My own best guess is that we will look back on this downturn as a more-or-less standard 10-year cycle, not a disastrous 30-year one. The aspect that will make it stand out is the transition to price stability. The equity markets will recover next year, maybe even next month. There may have to be some kind of global financial rescue package – concerted cuts in interest rates and a budget boost in the developed nations – but perhaps that won't be needed.

By the end of next year reasonable growth will be re-established in the main developed countries. We will then have several years of growth, difficult and disappointing growth but growth none-the-less.

That is not a heroic outlook but not a dreadful one – if we can keep our heads when all about us ....