Last week I wrote that Britain was suffering the economic equivalent of a heart attack and desperately needed first aid from the Bank of England, in the form of an immediate reduction in interest rates. Luckily, the Bank obliged, as did the US Federal Reserve Board on Tuesday afternoon. The immediate danger may therefore be over, despite yesterday's sharp falls in stockmarkets, which often get initial reactions to economic actions completely wrong.

But many readers have asked how could I possibly reconcile my strident demands for Bank of England rate cuts with my earlier assessments that the US credit crunch was little more than a storm in a teacup and that the world economy faced no serious threat of recession?

My answer is “very easily”. The two positions described above are entirely consistent. I make this point not only in self-justification but also because it points to a key misconception about the economic and political outlook for 2008: the idea that the main risks to the world economy today originate from the US. Gordon Brown, echoing the conventional wisdom of the capitals of Europe, keeps repeating the claim that any economic setbacks in Britain next year can be blamed on the American mortgage crisis. It has, however, no basis in facts.

The US economy has in reality been doing quite well this year, despite the collapse in the housing market — and even though a slowdown in the next few months is likely in response to the mortgage crisis, a strong recovery is almost certain to follow by the second half of 2008. This is why I felt justified that the agitation on Wall Street for additional rate cuts could be described as a self-serving tantrum and why the Fed will probably reverse course and start raising interest rates by the middle of next year. In Britain and Europe, however, the outlook is entirely different — and monetary policy should take this into account.

There are several reasons for believing that Europe and Britain will face much bigger economic problems next year than the US. The first is quite simply one of cyclical timing. While serious recessions usually occur only once a decade, economies often suffer a temporary slowdown in the middle of a typical ten-year business cycle. This slowdown is usually caused by tighter monetary policy and tends to begin about 18 months after rates begin to rise. The US is now near the low point of its mid-cycle slowdown, which began in late 2005, exactly 18 months after US interest rates started rising in June 2004. But the corresponding slowdown in Europe has only just started, partly because monetary policy was only tightened in December 2005. Since interest rates in America stopped rising in June 2006, the standard 18 months lag suggests that the US slowdown will soon be over, while conditions on this side of the Atlantic will continue to deteriorate throughout next year.

If we consider the nature of this deterioration, we can understand the other reasons for worrying much more about Europe and Britain than the US. In America, the housing and mortgage markets have proved the weakest links in the present slowdown — and a similar downturn can now be observed on this side of the Atlantic, but with the crucial difference that housing markets are far more overheated today in Britain and much of Europe than they ever were in the US.

While US house prices rose by 50 per cent in real terms in the eight years to late 2005, the corresponding increase was 125 per cent in Britain, 120 per cent in Spain and 80 per cent in France. House prices in most European markets are also much more overvalued than in America when underlying determinants such as rents, interest rates and average earnings are taken into account. Even more surprisingly, considering the planning and land-use constraints often thought to justify high house prices in Europe, the increase in housebuilding in much of Europe, including parts of Britain, has been even more extreme than it was in the US. In Spain, for example, a survey reported in the Financial Times last week found an oversupply of one million newly constructed houses. This compares with an excess inventory of 520,000 new houses in the entire United States. The oversupply in Ireland, Denmark and Greece is equally extreme and even in France and Britain housing investment is now almost double the US level in relation to GDP. A correction in housebuilding and property prices therefore seems inevitable, not only in Britain but in much of Europe.

To blame this on the US sub-prime mortgage crisis is like saying that nightfall is caused by the hooting of the owl. It is even more absurd to criticise the Bank of England for easing monetary policy in response to this outlook, since rate cuts today will not prevent the fall in house prices that has already started, but they may prevent the inevitable correction in housing from turning into a slump embracing the economy as a whole.

How could such a generalised slump be avoided in Europe and Britain? To answer we must again look across the Atlantic. The US economy has grown robustly this year, despite the collapse of housing, because of an export boom. Since the summer of last year, the US trade deficit has shrunk by 1.5 per cent of GDP, roughly offsetting the 2 per cent of output lost through the housing slump. Sadly, however, no such relief from exports can be expected for Europe and Britain. On the contrary, export growth is likely to slow dramatically next year, exacerbating the slump caused by housing. This is because the falling dollar has made American companies far more competitive than ever, but China and Japan have protected their industries from the resulting competitive pressures by preventing their currencies from rising significantly against the dollar. Europe and Britain, by contrast, have allowed their currencies to appreciate steeply against the dollar, the renminbi and the yen. The implication is that any further narrowing of the US trade deficit in the next few years will occur at the expense of Europe. If the US deficit shrinks by another 2 per cent of GDP in the next year or two, which seems quite likely, Europe and Britain will suffer a corresponding 2 per cent loss of output, on top of the inevitable contraction in housing.

How could this dismal prospect be avoided? Only by following the US example of steadily cutting interest rates and pushing down the currency. In truth, though, it is probably too late. With sterling and the euro so overvalued and housing markets already falling, a major slowdown probably cannot be avoided. The best hope is to minimise the damage that is now more or less inevitable in Europe and Britain. The Bank of England started to do so last week, while the Fed may have completed the corresponding process in America on Tuesday. Meanwhile, the European Central Bank has not even noticed the risks.

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