It was not quite the way they expressed it, but the message from the policymakers at Davos was clear enough: Plan B is swinging into action. What is Plan B? Two weeks ago I wrote on this page that the global credit crunch was near its end – in terms of time, though not necessarily of price. What I meant was that stock market prices might still fall a long way and some financial institutions might even go bankrupt, but the time for these events to happen was running out. If by February, private investors and bankers had not come up with some kind of market-based resolution of the crisis (which was everyone’s “Plan A” hope and expectation back in the summer), then politicians, central bankers and regulators would surely step in with a “Plan B”.

The reason for picking February as the decisive moment was that leading banks and insurance companies around the world would by then have reported their year-end results. In doing this they were certain to announce big write-offs and huge capital-raising operations to repair their balance-sheets after the damage done by the sub-prime crisis. The hope and expectation among policymakers was that markets would view these recapitalisation efforts as the end, or at least the beginning of the end, of the global credit crisis. If that were the case, then normal financial conditions would gradually be restored in the global economy in the next six months or so. If, however, investors and analysts continued to question the solvency of major financial institutions, then there was really nothing more that the private market system could do to restore order. To wait for the financial system to cure itself after the next quarterly round of result announcements and recapitalisations, would seem futile, since the same uncertainties about the future would continue to cloud investors’ judgments for another three to six months.

Meanwhile, the damage done by continuing financial paralysis to the real economy of jobs, investment and consumption would escalate rapidly. Just as an aircraft needs to fly faster than a certain stall speed in order to stay aloft, any market economy needs to grow faster than some minimum rate in order for the normal circular motion of incomes, consumption and profits to keep flowing. If an economy falls below this stall speed – which in America and Britain appears to be roughly a 1.5 per cent growth rate - for more than a couple of quarters, then it will almost certainly crash all the way into recession, with unemployment rising sharply, profits collapsing and financial default rates soaring far beyond the levels seen so far.

This is a risk that rational policymakers simply would not accept – which brings us back to Plan B.

In the days after the mammoth recapitalisations announced this month by Citibank and Merrill Lynch, the two financial institutions worst hit by the sub-prime crisis, it became increasingly clear that market forces alone were not going to resolve this credit crisis. Despite the $15 billion of new capital raised by Merrill and Citibank, investors remained deeply sceptical about the financial prospects and even the solvency of these two linchpin financial institutions. This scepticism partly reflected the unimpressive performances of the new Merrill and Citi management teams, particularly their refusal to make big structural cutbacks and to slash employment costs at these clearly dysfunctional companies.

An even more urgent reason for worry was the downgrading of the monoline bond insurers, a handful of relatively small financial institutions that guarantee several trillion dollars, euros and pounds’ worth of quasi-government debt around the world. Even more alarmingly, in the present context, these bond insurers theoretically stand behind many of the credit default swaps and other specialised financial products that banks such as Merrill and Citi have used to hedge the risks of their exposures to mortgage bonds and other assets, which have been threatened with default. If these bond insurers went bankrupt, not only would local governments across America, infrastructure projects in Europe and Public-Private Partnerships in Britain find it much more difficult to raise new credit, many of the banks that have claimed in the past few weeks to have hedged serious potential losses would find themselves exposed again to tens, or even hundreds, of billions of dollars’ worth of risky loans.

That the US Government simply could not tolerate such a situation was revealed in three events last week. The first was, of course, the emergency cut in interest rates from 4.25 to 3.5 per cent, announced by the Federal Reserve Board on Tuesday, which will certainly be followed this week by a further cut, either to 3.25 or 3 per cent. The second was the $150 billion fiscal stimulus plan, due to be announced formally by President Bush in his State of the Union message this evening and negotiated in Washington with what one of the top American policymakers at Davos described as “simply stunning speed and absence of partisan rancour”. The third was the revelation that New York’s Superintendent of Insurance had called a meeting of Wall Street’s leading bankers to try to raise $10 to $15 billion for a collective financial lifeboat to save the struggling bond insurers.

Interestingly, it was this third element of the US Government’s Plan B, which received much less attention than the other two components, that actually triggered last Wednesday’s spectacular rebound in share prices on Wall Street. This made a lot of sense. Cuts in interest rates and taxes of the scale announced last week certainly will boost the US economy’s growth rate, but their full stimulative effects will not be felt for many months – and the normal lags in the operation of monetary policy will be greatly aggravated if the US banking system remains paralysed.

To be fully convincing, therefore, a US anti-recession plan also had to include targeted financial measures to clear the blockage in the banking system, now that the market system has proved unequal to this task. And, as a senior US economic official pointed out to me at Davos, another important but little-noticed measure of this kind – a temporary increase from $417,000 to over $730,000 in the maximum loan size that could be guaranteed by Government-sponsored mortgage institutions – was included in the $150 billion fiscal package announced last week.

The fact that US policymakers have decided to recognise that the credit crisis has degenerated into a clear case of market failure, justifying government intervention, was the most encouraging feature of last week’s events. The can-do spirit of the American political system and the pragmatic attitude of US policymakers in seeking non-market solutions in an emergency, even when these conflicted with generally free-market ideological views, was a cause of almost unanimous admiration at Davos. While nobody was willing to say this openly, the change in mood, especially among the American businessmen and officials, after the despondency of Tuesday morning, spoke eloquently on this theme. As a result, the risks of a serious recession - at least in America – are now much smaller than they appeared even a week ago.

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