After the stock market's worst half-year since the early 1990s, nobody - not even I - can deny any longer that financial assets around the world are in a severe bear market. But with so many of the world's most important markets last week retesting their post-credit crunch extremes - the FTSE at 5,500, the S&P 500 at 1,280, oil at $140 and the euro at $1.60 - it seems worth asking the defiant Churchillian question: Is this the end of the beginning or the beginning of the end? Is the bear market only just starting and about to break down to much lower levels? Or is it possible that last week was a test of the lows hit by equities and the dollar in the credit crisis and the high hit by oil two weeks ago?

You might say that this hardly matters. The financial markets are a casino and therefore of interest only to gamblers, clairvoyants and cheats. Politicians, businessmen, homeowners and consumers should focus instead on the economic fundamentals and an article such as this should try to explain whether these are really better or worse than suggested by the media headlines and the stock market talking heads. The trouble with trying to focus on fundamentals, however, is that these fundamentals are themselves enormously affected by financial behaviour. In a world in which politicians and investors believe that the market price of oil tells us more about supply and demand than any amount of statistical analysis, the doubling of oil prices in the past 12 months appears to have rendered irrelevant all the fundamental analysis which has been pointing to lower oil prices for the past 12 months - even though demand for oil is falling and supply is gradually rising, in precisely the way that economists would predict when the price of a commodity goes up.

The sensible economist's response to the paradox of rising prices at a time of falling demand and increasing supply would be to try to understand the reasons for this market failure - in this case, most probably herd-like behaviour of momentum-driven investors, of the type we saw in the credit bubble, the housing bubble, the internet bubble, the Japanese bubble and so on.

We live, however, in a world of naive market fundamentalism, where politicians and media commentators assume that the market is always right, despite the copious evidence that markets are often very wrong indeed. In these conditions, financial market movements can sometimes become self-fulfilling prophecies - if bank shares keep falling they can cause financial crises and recessions, simply because the world starts to believe that investors must “know something” about banking solvency that is not apparent to the naked eye. Similarly, if oil and commodity prices keep rising, they can create a permanent inflationary psychology, if consumers and producers conclude that the market must “know something” about the world running out of energy and food.

Oil is the key to world recovery

The shock of $140 oil has created inflationary and deflationary pressures that threaten world economy and policy tools

• Former President Bush energy adviser says oil is running out

BACKGROUND

• Oil is the key to world recovery

• Banks may need to pump billions into scheme

• UK economic growth weakest for three years

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• Full credit crunch coverage

BACKGROUND

• Happy days are over for UK households

• Banks restrict mortgages by brokers

• Credit crunch halves lending at Nationwide

• JPMorgan to cut Bear Stearns jobs

• George Soros: Crunch will bite deeper in UK

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• Former Bush adviser says oil is running out

To try to understand the gyrations of financial markets - or at least to respond to them in a calm and rational manner - is therefore an essential part of the policy-orientated economist's job. What, then, can we sensibly say about the awful developments in all the financial markets this month?

There seem to be three main anxieties linked to the present bear markets: the fear of recession, the risk of inflation and the spiralling price of oil.

The possibility of a serious US recession, which has dominated most media and market comment since the credit crunch began in America last summer, is in my view the least plausible of these threats. Statistics suggest that the US economic slowdown is already at or near its low-point and the risks of a serious recession are rapidly diminishing. GDP, consumption, industrial activity and employment have all been consistent with a fairly typical mid-cycle slowdown and none have fallen sufficiently to signal even a mild recession. In short, the cautiously optimistic assessment of last week's Federal Reserve communiqué seems to be justified by the statistical facts: “although downside risks to growth remain, they appear to have diminished somewhat” since the last FOMC. Of course it is possible that the US economy will deteriorate in the months ahead, but this seems unlikely, given the huge tax cuts and interest rate reductions to which American consumers are likely to start responding in the second half of this year.

Britain and Europe, on the other hand, are only just entering the bust phase of the credit and housing cycle that started in America almost two years ago. The scale of these credit busts is likely to be at least as severe in the UK and Europe as it was in America, for the simple reason that the credit and housing booms were even bigger on this side of the Atlantic.

Moreover, exchange-rate policies imply that US industry and employment will recover mainly at Europe's expense. All this means that, in the year ahead, a serious recession is a much bigger threat for Britain and Europe than in America.

Having said this, however, there still seems a decent chance that Europe and Britain may avoid recessions for the same reason as the US - consumers and non-financial businesses are turning out to be much less vulnerable to credit tightening and falling property prices than widely assumed.

But if a global recession is likely to be avoided, why are investors in such a funk? The answer is that most now see inflation as a much greater threat than recession. This makes sense, but only up to a point. The bad news is that inflation is much harder to cure than weak growth or unemployment because the remedies required - higher interest rates and cuts in government spending - are painful to implement.

The good news is that inflationary pressures in the US, Britain and the eurozone are still fairly weak - and will get steadily weaker in the year ahead, as house prices keep falling, consumption growth slows and unemployment drifts up.

I suspect that what really worries investors in the US and Europe is not really the likelihood of high inflation, but the risk that central banks will over-react to inflation fears. If central banks are paralysed by fears of igniting inflationary expectations they may stop supporting financial institutions through the credit crunch. This idea seems to be behind the panic selling of financial stocks. In addition, there is a growing worry that developing countries, including China, will be overwhelmed by inflation, like Italy and Britain in the 1970s, instead of learning to tame it as did Germany and Japan. A long period of disappointing performance from the developing countries would be a big shock to the world economy, since global growth depends increasingly on emerging markets. US consumption growth, while it is not collapsing, is bound to be much weaker in the next decade than it was in the last.

On this interpretation, the real worry for financial markets is neither recession nor inflation, but rather the policy paralysis caused by $140 oil. The oil shock has created a pincer movement of inflationary and deflationary pressures that is not only threatening the world economy but also disabling the policy tools of Western governments and central banks. This is why I have always said that another oil shock is a far greater threat to the world economy than any conceivable credit crisis.

The future of the world economy now depends entirely on whether America and Europe can stop the feeding-frenzy among investors that suddenly pushed oil above $100 four months ago, even as demand began to collapse. What is ailing the world economy is now quite simple: it is $140 oil. If investors come back to their senses, the oil price will fall back below $100 after the summer and the second half of this year will prove less traumatic than the first. But in the unlikely event that oil is still trading above $140 by the year-end, all bets are off on world economic prosperity.

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