Samuel Brittan explains why enough has probably been done to prevent recession spiralling out of control

If there are two imperfect sciences, they are geopolitics and macroeconomics. Yet since the outrage of September 11, any realistic discussion of the outlook has had to combine elements of both.

Let me first cite the latest Global Economics Weekly issued by Credit Suisse First Boston: "The war in Afghanistan is not yet won but a decisive point seems to have been passed and investors face a world in which China, Russia and America are overtly on the same side for the first time. We think one obvious result is to help stability and reduce the weight of the more outrageous risk scenarios."

We must hope that CSFB is right. But in an Economic Viewpoint of October 11 I examined opposite assumptions, namely that the Afghan war was likely to be only the first phase of a much longer conflict. I went by US military pronouncements that the struggle against terrorism would be drawn out and costly. Once the immediate recession blues were over, the real problem would be how to finance an expensive war effort without an inflationary overload; this then led me to cite Keynes's How to Pay for the War.

These two opposite views have one aspect in common. They make it unlikely that the world will have to face a big deflation. In the optimistic CSFB case, confidence worries will lift and the recent monetary stimuli will raise demand and output, instead of just going into precautionary cash balances. In the more pessimistic case, the sheer weight of military spending would eventually offset any slump worries and bring us back to familiar problems of inflationary overheating.

There is, however, a third possibility that would be compatible with prolonged recession. This is that there are enough further scares and terrorist attacks to hit confidence again; and yet the military and security response is a series of relatively small-scale campaigns that does not have much impact on world demand and output.

The new Economic Outlook of the Organisation for Economic Co-operation and Development (OECD) does not venture into this highly political realm. But it is among the first official analyses to take September 11 seriously. The OECD still emerges with a central forecast of a recession not too different in scale from past ones, with no year-on- year drop in output, merely a slowing down to 1 per cent growth this year and next. But it lists downward risks such as a deeper-than- expected deceleration in consumption or investment, a stalling of non-OECD demand, a surprise rebound in oil prices and a dollar depreciation. One should therefore ask whether the main forecast is really a central one or whether the OECD is playing safe.

The report confirms that the present world recession had its origins in the US high-technology bubble, which was destined to burst. This led to a fall in Wall Street and a severe blow to confidence, even before the destruction of the twin towers. There have been very few hard data covering the period since then.

And, as usual at critical points, what data there are point in opposite directions. There was in October a surprisingly steep drop in US industrial production, which fell for the 13th consecutive month, but a sharp rebound in retail sales. It is obviously too early to extrapolate from either. But in contrast to most postwar recessions, the downward influence has come from the industrial sector, where investment has been slashed. The stabilising factor has been personal spending, which has held up quite well.

The interest rate cuts in the US and the eurozone have been reflected in monetary expansion. Mervyn King, deputy governor of the Bank of England, has recently expressed concern over the neglect of money supply indicators by central bankers, himself included. This is probably because their influence is over several years; they are little help in short-term policy.

The large increase in broad money growth will probably lead to a rise in both nominal and real spending, even without military emergencies; and financial markets may be premature rather than wrong in predicting a 1 percentage point rise in US short-term interest rates over the next year.

At the other end of the opinion spectrum, the big worry of the pessimists is that prices will fall so much that reductions in nominal interest rates will not continue to feed through into real interest rates. The fear is of a liquidity trap in which injections of money into the system will simply result in the hoarding of cash or - if you want to put it that way - a fall in the velocity of circulation.

This is running too fast. Outside Japan, prices are not falling, simply rising much more slowly, year on year. In a world of stable prices or very low inflation, there are bound to be short periods of falling prices. Moreover, individual price series will diverge. Not all prices can march slowly together in one straight line. In the US producer prices have dipped. But so far the drop in producer prices has been less than in the past two recessions; and at least as much importance should be attached to consumer prices and the gross domestic product deflator - still clearly positive.

Central banks should, of course, make plans to avoid getting into a Japanese situation. There are many expedients that can be used to avert a liquidity trap. Central banks can buy bonds from the public; and in a real deflationary emergency governments could do the same and finance these purchases by bank borrowings. This would be contrary to the prudential regimes that have been put in place with so much effort but which need to be put aside in exceptional situations.

What role would there then be for fiscal policy? A large fiscal stimulus is under way in the US, estimated by the OECD at nearly 2 per cent of GDP on a cyclically adjusted basis. The eurozone has been inhibited by the stability pact, which has allowed European budgets to deteriorate in line with the business cycles but no more. For the moment one need not quarrel. But just as the Bank of England would temporarily put gold convertibility on hold by suspending the Bank Charter Act in the heyday of the Gold Standard, eurozone countries should do the same with the stability pact if the downward risks enumerated by the OECD were to occur.

These brief suggestions are a reminder of the need for contingency planning, which was so lacking during the Great Depression and in Japan in the 1990s. But my own view is that a more likely problem will be that of phasing out recent stimuli before they put hard-won price stability at risk.