Playing with fire

AS THE thunder of applause pulsating around Saviles Hall trickled to a halt, Mervyn King shuffled his notes and rose to his feet. In an economic storm that has fed off the unforeseen, it was time for the Governor of the Bank of England to land his own bombshell. In a speech to an audience of plain-speaking Yorkshiremen in no mood for prevarication, King laid bare the devastation left by the worst financial crisis in living memory, predicting that house prices would fall further and that economic hardship would last for years.

"The combination of a squeeze on real take-home pay and a decline in the availability of credit poses the risk of a sharp and prolonged slowdown in domestic demand," he told members of Leeds Chamber of Commerce. "It now seems likely that the UK economy is entering a recession."

It was a first: no other Treasury minister or leading Bank official had mentioned the dreaded 'r' word, and its impact was seismic. King had wanted Tuesday's speech to mark the start of the "long march back to boredom and stability". It had the opposite effect. At one point sterling notched up its largest fall against the dollar in 16 years, while the Prime Minister was forced to admit that the recession is upon us.

A day later, Cabinet ministers and civil servants gathered in Gordon Brown's 'war room' – a large L-shaped space in the heart of Downing Street where Brown, his two Cabinet office ministers and some 20 civil servants, including Jeremy Heywood, Jeremy Bowler and Gavin Kelly, were gathered. The office is a replica of the one run by New York City mayor Michael Bloomberg. Adjacent to the hub is a small private room reserved for Brown's telephone conversations. By Wednesday night he had spoken directly with the Greek prime minister, Kostas Karamanlis, and President George Bush. With stock markets around the world continuing to rack up spectacular falls, the work to fix the global financial mess had begun.

In Scotland, First Minister Alex Salmond presided over a hastily convened economic summit with Scottish Secretary Jim Murphy. After a 90-minute meeting, just days after relations between the Scottish and Westminster governments descended into insults over the bank bailouts, a statement was issued pledging cooperation for the benefit of the Scottish economy.

Back in Westminster, the war-room announced its first package of measures designed to help small firms and homeowners through a recession. With figures showing that repossessions have soared by 47% in the first half of this year weighing heavily on his mind, Brown decreed that courts should halt all actions to repossess homes until every alternative had been "fully examined".

In a meeting with British bank chiefs at 11 Downing Street on Thursday, Chancellor Alistair Darling and Lord Mandelson, the new Business Secretary, piled pressure on UK banks to up their lending to small firms. Hours later, the Government and bank bosses – including John Varley, chief executive of Barclays; Eric Daniels, chief executive of Lloyds TSB; and Gordon Pell, a director of Royal Bank of Scotland – announced the creation of a forum for small businesses to address the problem of curbs on lending.

Amid all the frenetic activity, however, questions are still being asked: will it work and, if governments around the world are running out of answers, who is there left to sort out the mess?

"The UK Government could bring forward infrastructure projects such as building schools or transport links, as well as maintaining the present level of public spending, effectively borrowing from future taxpayers to spend now," says Tom Miers, a political consultant. "The downside to that is that you can never be sure that the money will benefit the right people fast enough. The other option is to cut taxes, which is quicker and targets the economy as a whole."

It is a view echoed by Scottish Liberal Democrat leader Tavish Scott, who has suggested exactly this approach by calling for a 2p cut in income tax. The Conservatives also support tax cuts. They have given the example of Japan in the 1990s as proof that spending cannot always stimulate the economy. Other Conservative proposals include deferring payment of value-added tax for firms employing up to 250 workers for six months, while those firms with a wage bill under 150,000 would get a cut of 1% in their national insurance contributions.

CBI Scotland has stepped up the pressure on the Scottish Government, demanding a series of measures, including privatisation of Scottish Water and scrapping of the local income tax proposal, as a means of helping businesses cope with the combined worldwide effects of the downturn.

But while all these may go some way towards alleviating the crisis on the shop and office floor, growing global nervousness about a deep recession was extending beyond national and regional governments to a higher authority. As politicians around the world beavered away on the domestic front, Dominique Strauss-Kahn, head of the International Monetary Fund, was in Washington masterminding a rescue of several former Soviet states and Pakistan.

The IMF is talking to Belarus this weekend about a loan programme, with some reports saying the Belarus government has asked for as much as $2bn. Hungary, Ukraine and Serbia have also turned to the IMF for loans in recent weeks. Strauss-Kahn also confirmed that Pakistan has sought IMF assistance despite initial reluctance from the new civilian government, which has taken over from Pervez Musharraf.

With $200bn on the IMF balance sheet, there are those who ask if Strauss-Kahn will be the one left to clear up the mess if Brown, Europe and the US fail in their efforts to control the so far irrepressible economic storm.

But Catherine Schenk, professor of international economic history at the University of Glasgow, says it is highly unlikely that developed economies will turn to the IMF – even as a last resort.

Since the 1980s, the IMF has predominantly focused on emerging countries, and has played a peripheral role when it comes to the larger global economies. The IMF will be present at the emergency Group of 20 summit in Washington on November 15, but it is national governments that will continue to take the lead in solving the crisis, she says. "The problem with borrowing from the IMF is they impose very strict conditions. It's really difficult for governments to adhere to those during an economic crisis."

Schenk points out that a lot of confidence was lost in the IMF's ability to resolve economic crises in the 1990s. It stepped in during situations such as the Mexican peso crisis and the rouble crisis, but the extent of its lending during the last decade aroused criticism that it was allowing certain national governments to do as they pleased, then automatically bailing them out with few questions asked. That, according to economists, created "moral hazard".

Schenk says: "During the 1990s the IMF was very active, but they lost a lot of credibility over those crises. That episode (in history] really has pushed the IMF to the sidelines. The last time the UK had a big bailout was in 1976, and it was a huge national embarrassment."

Although Gordon Brown has called for an international agreement to overhaul global financial regulation, Schenk argues it is highly unlikely that national governments will come to any agreement – either at the G20 summit next month or at later meetings. She points to recent attempts to coordinate efforts to stem the crisis in Europe. After it appeared that consensus had been reached, German Chancellor Angela Merkel then struck out on her own.

Schenk says: "In the end, national governments want sovereignty over the regulation of their financial systems."

Hopes that countries such as China will come to the rescue of struggling developed economies may also prove short-lived. There are mounting concerns over the strength of the 'rising Dragon' economy after Chinese government figures published on Monday implied that the great Chinese boom had come to an end, as growth slowed to its lowest level in five years in the third quarter of this year.

Spooked by the figures, Chinese officials worked overtime to rush out a wave of measures to fire the economy up again. On Tuesday it announced it was increasing export tax rebates on more than 3,000 products, including toys and textiles. But markets in Asia were unconvinced. Authorities quickly responded by announcing late on Wednesday plans to shore up the wavering Chinese real-estate market. These included reducing the size of the down-payment Chinese citizens are required to make when they purchase a new home, and a waiver on stamp taxes for real-estate deals. But again, the measures evoked a lacklustre response from the markets, forcing Zhu Min, vice president of the state-owned Bank of China, to warn on Thursday that China too should brace itself for a downturn. "We shouldn't think we are outside the financial crisis," he said.

In Washington, Alan Greenspan, who stood down as chairman of the Federal Reserve in 2006, admitted that he had been "partially wrong" in his light-touch approach to regulating certain parts of the financial system. As head of the Fed from 1987 to 2006, Greenspan presided over much of the excess lending and expansion of the sub-prime mortgage market in the US that prompted the global economic crisis.

Being cross-examined by a congressional committee, he said: "I have found a flaw. I don't know how significant or permanent it is. But I have been very distressed by that fact. Partially… I made a mistake in presuming that the self-interest of organisations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms."

BY FRIDAY, Mervyn King's worst fears had been confirmed. Figures from the Office for National Statistics showed Britain's economy shrank for the first time in 16 years between July and September. The bets are now on that the UK will have entered a technical recession by the time the ONS publishes its next figures in January. Meanwhile, sterling continued its downward spiral against the dollar, and Opec announced it will slash oil production by 1.5 million barrels from next month.

With a cacophony of voices calling for an interest rate cut, King faces another difficult week when he sits down at his desk tomorrow. The Governor knows all too well the criticism that will be fired his way if the Monetary Policy Committee votes against another drop in rates when its members meet next week.

But the decision to slash rates for a second consecutive month is not an easy one to make. Inflation is still well above the Bank's 2% target, and the rapid decline in sterling has made the case for a cut that much more difficult.

The possibility of another spike in oil prices following Opec's decision to slash production also means that the route is not yet clear for further dramatic falls in interest rates.

But King's phone will continue to ring off the hook this week as business groups step up their campaign for the MPC to take the bull by the horns and make another bold decision on rates.

As Richard Lambert, director-general of the CBI, says: "Business needs a further 0.5% cut in interest rates soon.

"Other policy initiatives also need to be urgently considered. Any plans that add 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 on the high street more money in their pocket."