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Thanks to Alistair Darling, prices in the shops are coming down. From next week the cost-conscious consumer will be able to snap up a £550 flatscreen television for £538.38 and save £6.38 on a £300 washing machine. That's assuming, of course, that retailers pass on all the 2.5% reduction in VAT rather than plumping for round numbers: £10 off the TV and £5 off the washing machine.
Lower prices will encourage spending. A contraction in the British economy in 2009 that would have equalled 1.5% of national output will be limited to a 1% drop, with activity starting to recover from the summer of next year onwards. The Labour party will be able to go into the next election boasting that, unlike the Conservative governments in the recessions of the early 1980s and 1990s, it did not leave communities to rot, and that its bold action paid off.
That, at least, is the theory. In reality, Gordon Brown's chances of being re-elected depend on whether this is a so-called V-shaped recession - one that is comparatively brief in duration - or a much deeper and longer affair.
The chancellor's argument for a rapid descent into recession followed by a relatively rapid recovery is optimistic but not unreasonable. The economy has received a fivefold stimulus since the turn of the year from lower interest rates, lower taxes, higher spending, cheaper oil prices and a fall in the value of sterling. The weaker pound helps exports because they become cheaper; lower oil prices push up real disposable income; the easing of monetary and fiscal policy encourages consumer spending and investment. With inflation falling sharply during the first half of next year, people will find that they can buy more with their monthly pay cheque and - assuming that the financial markets have returned to something like normal - it is reasonable to expect a pick-up in demand during 2009.
As things stand, however, there seems to be little prospect of the financial markets returning to anything like the conditions that existed before the onset of the credit crunch. Mortgage lending has collapsed over the past 15 months - partly because demand has weakened and partly because the inability of banks to access funds from the City's wholesale money markets means they no longer have as much to lend.
Mervyn King, the governor of the Bank of England, said yesterday when appearing before the Treasury select committee that the most pressing domestic issue for policymakers was to ensure that normal levels of bank lending were resumed. "Without that, the downturn in activity could become protracted and extremely damaging," he added. King is absolutely right in his analysis: government action to implement the recommendations of Sir James Crosby's report on the dearth of mortgage funding would be far more significant in boosting the economy than a 13-month VAT holiday.
Nick Parsons, the head of strategy at the Australian bank nabCapital, noted yesterday that while Easter eggs might be 10p cheaper next spring as a result of the VAT reduction, the fact that house prices were coming down by £3.97 every hour would knock £10,000 off the cost of the average property in the same period. That puts the fiscal boost into context. The housing market is not going to recover until first-time buyers clamber on to the property ladder - and by insisting on 25% deposits and withdrawing low-cost mortgage products the banks are making it clear that they are not exactly falling over themselves to attract new customers.
So what sort of recession is the UK likely to have? The big fear is of an L-shaped recession, which is where an economy falls off the edge off a cliff and remains unconscious for a number of years thereafter. The classic example of an L-shape is the Great Depression of the 1930s, when the Wall Street crash of 1929 precipitated a four-year slump in American output that reduced national output by 25%.
While the current financial market crisis is the most acute since the 1930s, the determination to avoid the policy mistakes of eight decades ago means a second Great Depression appears highly unlikely. That is partly because welfare states are much bigger than they were in the 1930s, and help cushion the impact of recession. But it is also because policy has been eased more quickly, banks have been rescued rather than being allowed to go to the wall, and countries have, so far at least, not fallen back on beggar-my-neighbour policies.
There are two other possibilities for the UK - neither attractive, but both plausible. The first is a W-shaped recession, where the economy contracts, starts to recover but then suffers a relapse. Often this sort of protracted downturn is caused by policy errors: taxes or interest rates are raised too quickly because finance ministers and central bankers believe wrongly that the economy is out of the woods. The risk of that happening in the UK over the next couple of years is high.
Darling in effect announced two budgets on Monday: a tax-cutting budget for today, and a tax-raising (and spending- cutting) budget for 2010 and 2011. Similarly, the deep cuts in interest rates from the Bank of England to historically low levels are not going to last for ever. King did nothing yesterday to hose down expectations that Threadneedle Street may push the bank rate down to 1% over the coming months; but the bank will be keen to avoid the mistake made by then Federal Reserve chairman Alan Greenspan in the US earlier this decade, when he left borrowing costs too low for too long. The conduct of both fiscal and monetary policy involves fine judgments: acting too early could bring a nascent recovery to a halt.
That leaves a U-shaped recession, which is really just a longer and more painful version of a V-shaped downturn. The longevity and the severity of the credit crunch suggests, at present, that the former is more likely. For Darling to get his V-shaped recovery everything, but everything, has to come right. Consumers must start spending, world trade must pick up, banks start lending, firms stop firing, houses start shifting. It's not impossible, but the chancellor will need all the luck going.
• Larry Elliott is the Guardian's economics editor larry.elliott@guardian.co.uk
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