George Kerevan: Don't let banking chaos overshadow the real world

As output is measured by aggregating the myriad things that go on in the economy, I'm royally sceptical that you can have a quarter when GDP neither goes up nor down but sits, suspiciously, on the lip of contraction. However, even if we take these figures at face value, the UK economy is shuddering to a halt.

This fits in with the pattern seen in Europe. Output in the 15-nation eurozone contracted by 0.2 per cent in the second quarter and everything points to a further fall in GDP in the third quarter, qualifying as a full-blown recession. The European Central Bank is still talking about a slowdown and refusing to use the R-word, but unemployment jumped in France in August by 40,000 – the fastest rise in 15 years. This has prompted one of President Sarkozy's aides to talk about France being in a "quasi-recession" already.

Now here is the interesting thing: this slowdown in Britain and the eurozone kicked in at the start of the year, suggesting it is not principally a response to the current banking mayhem. More likely, the contraction is the result of rising commodity prices (especially oil) and high interest rates imposed by the Bank of England and the Euro Fed designed to squeeze inflation out of the system. Much of the second-quarter slowdown appears to be the result of a weakness in the production sector, which points to cost inflation and interest rates as the culprit. Industrial production across the whole 27-member EU economy was down by 1.3 per cent for the year to July.

What this tells us is that the effects of the credit crunch and the banking meltdown are yet to be felt in the economy. Certainly, the house-building and construction sector softened appreciably after the subprime crisis began in the autumn of last year. But the downturn in the building industry has only gathered real momentum since mortgage lending virtually collapsed over the summer – well after the second-quarter brake on output was evident.

Why does this matter? First, because what we might call the "second wave" of the credit crunch, which kicked in this autumn with the collapse of Lehman Brothers and the takeover of HBOS, has yet to impact on the real economy. And second, because if there are other factors slowing growth, we should not neglect to deal with them, whatever else is happening in the financial sector.

Some of the forces squeezing European production earlier this year may be easing to an extent. Oil prices have receded dramatically since July, largely on fears of a larger recession and a consequent drop in demand for fuel and other commodities. But there has also been a major shift in exchange rates.

Last year and early in 2008, the dollar was plunging on the back of the subprime debacle. Worried foreign investors were switching out of dollars, depressing their price. The upside for America was that a cheap dollar favoured US exports. However, the corollary was that both the pound and the euro gained in value, making British and European exports more expensive. That added to the negative factors causing the slowdown in output in the second quarter.

Now all that has gone into reverse. Amazingly, despite the banking mayhem and the failure of Congress to ratify the Paulson bail-out plan, the dollar is regaining value. The pound, on the other hand, suffered its worst one-day fall since 1993 on Monday – a fact lost amid the other disastrous news from the markets.

Perversely, though confidence in the dollar is volatile, the gridlock in the global money and inter-bank markets means that only dollar bills provided directly by the US Federal Reserve are keeping the world in liquidity. While Congress was busy vetoing the $700 billion bail-out plan, the Fed spent Monday stuffing central banks around the globe with another emergency issue of no less than $480bn greenbacks in an attempt to ease the global liquidity shortage. We might worry about US banks, but we just can't do without the dollar.

At the same time, money is pouring out of Britain, causing the pound to weaken. New figures show that there was a deficit of some 11bn on the current account – the difference between imports and exports – in the second quarter of 2008. This is huge deficit – the equivalent of 3 per cent of GDP. With liquidity ultra tight in the UK, we can't afford this kind of drain. There is a modest surplus on the external capital account (which takes into account investment flows) but even this is declining.

A cheaper pound, all other things being equal, will boost UK manufacturing exports, though your foreign holiday is going to cost a lot more. However, here is where the latest financial crisis kicks in. Private investment cash has fled the money markets, and banks won't lend to each other in case there is a default. As a result, short-term funds are hard to come by, which is curbing the availability of company working capital.

Consumer finance is also going to be affected: most of the consumer boom of recent years which underpinned growth was paid for through rising house values, equity release, and easy mortgages. The Bank of England remains convinced that the collapse of house prices won't reduce consumer spending, but if the link is through equity release, the Bank couldn't be more wrong.

Add these points together and the economic climate looks gloomy. Add them to an economy which is already in a downturn and the combination becomes lethal.

At this stage in the cycle, and with confidence already wobbly, there are few quick remedies. I favour an instant and bite-sized cut in interest rates to raise morale and lower bills. I'm aware that "real" interest rates are far above the nominal rate set by the Bank of England, but the demonstration effect of a cut would be useful. And it goes without saying the Bank should try to make a lower official rate "effective" by flooding the money markets with cash. My point is this: don't neglect the real economy just because of the banking crisis.