From good to bad to worse: three ways the credit crunch could end

There's a slightly spooky feel to the City a sense that the global financial crisis has just taken a turn for the worse. Diving share prices; interbank lending rates back to record spreads over government bonds; and bank shares trading below their rights issue prices, raising fears about their ability to raise fresh capital. Out in the real world, things look bleak, too: house prices are in freefall, Marks & Spencer has reported a huge drop in sales and the market fears several builders are in imminent danger of going bust.

When the credit crunch first appeared last summer out of a seemingly clear blue sky, most bankers stayed on the beach, assuming it would pass by September. Now no one is under any such illusion. This crisis will get worse before it gets better. The only question is how much worse? No one can honestly know the answer. It depends on far too many variables. This is a global crisis, where decisions taken in China, Russia, the Middle East and Brazil matter as much as anything US or European policymakers might do.

Inflation is on the rise in the West, but many developing countries now have double-digit inflation. No one knows how far high commodity prices, including oil, reflect fundamentals, or if they are a new bubble that will burst. At the heart of the uncertainty lie the banks, who continue to announce massive writedowns and whose balance sheets may conceal further unexploded bombs. That said, I can see three broad scenarios:

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1. Good outcome shallow downturn

By the end of 2008, the financial crisis is largely over. Central banks have already pumped enough money into the banking system to prevent another Northern Rock or Bear Stearns, where a bank goes bust for lack of cash. Meanwhile, the current round of capital raisings gives the banks enough of a buffer to survive the housing slump and any economic downturn. Gradually, confidence returns to the banking system, interbank borrowing rates fall, and prices of financial assets rise as fears of further firesales recede and bargain-hunters appear.

The real economy takes longer to recover. UK house prices continue to fall, which undermines consumer confidence and makes life tough for retailers. But this is partly offset by growth in exports as a result of the weaker pound and booming demand from developing countries such as China, Russia and India. The UK only suffers a mild downturn, rather than a full-blown recession. Meanwhile, oil prices start to fall as global demand for oil eases, leading to lower inflation and paving the way for interest rate cuts in 2009. As a result, the real economy starts to recover in 2010.

2. Bad outcome deep recession

The financial crisis persists well into 2009. Commodity prices remain high, fuelled by lax monetary policy and booming demand in developing countries. That results in persistently high inflation in the West, forcing central banks to keep interest rates high and even raise them. As a result, house price falls in the US and UK prove worse than predicted, leading to further big banking losses. Reluctant to raise yet more capital on deeply unfavourable terms, the banks restrict lending and raise the cost of borrowing. That leads to more personal and corporate defaults and a recession in the UK and US.

However, the recession proves short-lived. The oil price falls sharply on the back of slowing global demand, bringing down inflation and allowing interest rate cuts. As borrowing costs fall, house prices stabilise and bottom-fishers start to emerge in the credit and equity markets, allowing banks to write back some of their losses. That boosts their capital position, allowing them to raise lending. By 2010, the economy is growing again.

3. Doomsday outcome

The financial crisis goes from bad to worse. Central banks in developing countries such as China, India and Russia put up interest rates to contain runaway inflation that is threatening their domestic stability. Their domestic economies slow sharply, while their currencies soar, smashing dollar pegs. The subsequent plunge in the dollar and sterling leads to a sharp rise in inflation in the West, forcing the Fed and Bank of England to respond with higher interest rates. The result is a major recession, with savage falls in house prices and big rises in personal bankruptcies, job losses and corporate defaults. The recession adds to pressure on the banking system.

As losses mount, doubts about the solvency of many banks make it almost impossible to raise fresh capital. US and UK governments are forced to step in, leading to a wave of Northern Rock-style nationalisations, putting further pressure on government finances at a time when tax revenues are in freefall. The result is a loss of international confidence in the US and UK. Both are forced to hike interest rates again to finance national debt, leading to more economic hardship. In 2010, there is still no end in sight.

Which scenario is most likely? I hope the first, fear the second, and pray it is not the last. But anyone who claims to know the answer is a fool.

Simon Nixon is executive editor of Breakingviews.com