The simultaneous slide in the dollar and the US stock market since early last year is signalling a world economy perilously close to a global recession. If US spending stalls and a still weaker dollar exports more deflation, how is global recession in a world of excess capacity to be avoided?

This painful question has been largely ignored; until mid-summer, the world was mesmerised by the illusion of a US recovery. It is time to recognise that the desperate efforts of policymakers and sell-side analysts to "talk up" the economy and the stock market have become counterproductive. Feel-good chatter precludes much-needed stimulative measures. It is to be hoped that in coming weeks--not months--even fervent optimists will drop their dangerous pretence and get on with the urgent task of averting a full-blown recession. The US economy, we now know, experienced an unusually sinister recession during the first three-quarters of last year, during which investment fell so rapidly and persistently that overall growth turned negative despite an annualised consumption growth averaging 1.8 per cent.

Ominously, although first quarter growth this year reached an annualised rate of 5 per cent, investment spending continued to fall. Real final sales growth (a proxy for demand growth) slowed to an annual rate of 2.4 per cent, from a 4.2 per cent rate during the fourth quarter of last year.

Any notion of a "disconnect" between the "strong" economy and the weak stock market evaporated with the release of second quarter data and still weaker data for the first month of the third quarter. Second quarter growth fell to an annual rate of 1.1 per cent from the 5.0 per cent rate in the first quarter. The stock market, as it suffered during the second quarter, turns out to have presaged accurately the real economy's slowdown.

Thus a clear picture has emerged of an economy with very weak demand growth that was only temporarily jolted out of recession by interest rate cuts and the fiscal stimulus that preceded and followed September 11.

The loss of global wealth in the past two years, somewhere in excess of Dollars 12bn (Pounds 9bn), is now likely to continue during the remainder of this year. An unstable cycle of weaker demand growth, disinflation or deflation, and falling stock prices has taken hold of the global economy more firmly in 2002 than it had done in 2001.

This slowdown has been exacerbated by the facile assumption that persisted, in the face of contrary evidence, that recovery was under way. Companies that have started to hire or invest will now have to reverse course all the more abruptly because of the need to cut costs sharply in the face of weaker demand. Households that used easy credit to buy consumer durables or to chase rising property prices have taken on more debt and soon will have to cut spending--sharply.

Rational saturninity makes sense. The economic gloom has pushed the stock market down enough to depress spending further still and possibly produce another round of lower stock prices. Policymakers have few options. The Federal Reserve has 175 basis points remaining of short-term interest rate cuts. The fiscal stimulus is over; complaints from Democrats about tax cuts, coupled with a lack of political capital in the Bush administration, preclude further measures.

The European Central Bank worries about inflationary pressures while the eurozone's stability pact prescribes pro-cyclically tighter fiscal policy even as the economy weakens, perhaps even more rapidly (especially in Germany) than in the US.

Meanwhile, in Japan the central bank maintains a tepid expansion of liquidity with interest rates at zero while the Koizumi government is on track to tighten fiscal policy next year.

The sooner policy change comes, the less pain the global economy and its citizens will suffer. The US, Europe, and Japan need to combine to stimulate demand. On the monetary side, the Fed needs aggressively to pump up liquidity, and to signal initiation of this effort with a cut in the Fed funds interest rate of 100 basis points to 0.75 per cent. The resulting weakness of the dollar must be contained by asharp, unsterilised liquidity growth from the European Central Bank and the Bank of Japan.

Fiscal policy should be eased globally as well. Scheduled tax cuts in the US should be made permanent and brought forward. Europe must suspend its insane stability pact and add more tax cuts to fiscal plans. Japan should increase tax cuts on the books and pass them.

These measures will be inflationary. Let us hope that they succeed as advertised. It would be far better two years from now to be living with 3 per cent inflation and 3 per cent growth than with falling prices and stagnant economies. Central bankers who refuse to learn from Japan's policy mistakes of the 1990s should be removed--quickly--and replaced with those who want to stabilise prices. 

John H. Makin is a resident scholar at AEI.