There are methods of counteracting the downturn in the world economy but they can only achieve so much

Even the most pessimistic of analysts see some scope for official action to prevent a downturn from getting out of control. The one thing of which we can be sure about the present setback to the world economy is that nobody knows how long or deep it will be.

The epicentre of the present disturbance is the US economy. Stories of surprising consumer confidence are succeeded by reports of sagging business confidence. Even if there is some recovery in the second half of this year, we shall not know if it is a breathing space or the beginning of a durable recovery.

One disturbing sign is the reassuring statements that emerge from meetings of world finance ministers and central bankers. At the beginning of 2001 central bankers meeting at Basle proclaimed that a US recession was unlikely. Not long afterwards Alan Greenspan, chairman of the US Federal Reserve, warned of just this danger. This month finance ministers of the summit group spoke about "sound economic fundamentals" that would provide a solid foundation for renewed expansion.

I am reminded of the stockbroker who performed an invaluable service to his partners by being always wrong. Unfortunately, official world forecasts are not even uniformly bad.

There is a certain amount of consensus that we are back with the pre-1914 kind of investment-led business cycle. But the nature of the traditional business cycle is still a matter of dispute. We can distinguish two schools of thought. There are those who regard recessions as mainly reflecting a falling-off in demand for products or labour, which can be corrected by injecting more spending power. There is also a more pessimistic school that sees in a recession a penalty for previous indulgences.

According to the demand-based school, recessions are due to whatever causes total spending to falter. Policies to increase spending can take the economy back towards its trend growth rate, although not above it. This view is common to monetarists and Keynesians alike. These differ on the relative importance of monetary and fiscal policy, the difficulty of forecasting and rules versus discretion. But they basically agree that policies that maintain demand can cure recessions.

The more pessimistic school sees the origins of recession in the excesses of the previous boom. In its view, real and sustainable recovery will not be possible until the excesses have been corrected. There are different kinds of pessimists - the most respectable are the academic economists of Austrian vintage.

There is more than one kind of "Austrian". To those who follow Joseph Schumpeter, the Viennese economist who settled in Harvard, the mainspring of economic growth is a series of bursts of innovation. After each of these bursts there is a reaction, partly because the initial impetus has exhausted itself and partly because a pause is needed while the outdated forms of old economy equipment are gradually eliminated. This is known as the process of "creative destruction".

According to another variant, led by Ludwig Von Mises and Friedrich Hayek, the problem is that during the boom investment exceeds society's permanent willingness to save and is therefore distorted in an excessively capital-intensive direction. Full economic recovery has to wait until this mistaken investment has been corrected.

Hayek at least made one significant concession. While he insisted that the investment downturn would have to run its course, he did see a place for expansionary policies to prevent what he called a "secondary depression". This refers to a multiplier process in which a downturn in investment leads to reduced incomes, which in turn feeds into lower consumption and so on in a downward spiral. Unfortunately, this concept was not formulated in time to save the theory from intellectual annihilation.

The relevant point is the agreement among these schools of thought that a cumulative process, in which consumption and income lead each other downwards, can be avoided. It is helpful here to look at some orders of magnitude. Private non-residential investment, in which the past excesses are supposed to lie, has accounted in recent years for about 13 per cent of US gross domestic product. The overwhelming proportion of GDP - 67 per cent - consists of personal consumption and the second largest category - 17.5 per cent - consists of government spending.

Therefore, even if the pessimists are right about the excesses of the preceding investment boom, it is at least possible to cushion a recession by boosting consumption and government spending. With a Republican administration in Washington, the fiscal boost can be expected to take the form of tax cuts.

The practical question is: how far can we go in stimulating consumption- type spending to offset weaknesses in the investment component? It is not, of course, necessary to offset the full 13 per cent. Much investment is of a routine nature and will not have been affected by recent excesses. The extreme upper limit of reflation is that it should not go so far as to reignite either a new stock market boom or a new burst of unsustainable investment in the new economy. There is little danger of either of these happening. Investors in technology companies have surely been shaken enough by recent events not to go on another spree.

The question then boils down to how far central banks and governments can go in boosting consumer spending as a stabiliser. These are commonsense speed limits. The economy does not consist of a flow of coloured water - by which it was quite literally represented in early hydraulic national income models. There is a limit to the rate at which workers can move from providing electronic hardware or software to acting as barbers or shop assistants. Signs of the limits being reached would be the reappearance of inflationary pressure as shortages of workers and consumer products developed.

There is so far little sign of this. But there is another, more controversial, kind of limit. Before the downturn began, the American consumer was tightly stretched in terms of high debt and low savings ratios. While no one wants to see a downward spiral in consumer spending, a deliberate large boost to make up for shortfalls in investment could take the US consumer spending ratio into vulnerable territory in terms of susceptibility to a future shock.

The US private sector is already running a historically high deficit that has been financed by overseas borrowing, in turn mirrored in a record current payments deficit. And although the numbers are not so frightening, there are similar risks in other English-speaking economies - especially in Britain.