With the US economy now clearly in recession, the latest - and potentially most dangerous - phase of the global financial crisis is under way.

Phase One was the wrenching liquidity squeeze of last summer and autumn, caused by a flight from risk as banks belatedly realised the scale of the problems in asset-backed securities.

Phase Two was the surfacing of the capital insufficiency that lay at the root of these liquidity problems as financial institutions began writing down the value of their rapidly diminishing assets.

Unfortunately, these first two phases were not discrete, but overlapping, and now they are about to decant further into the most frightening and, perhaps, destabilising phase of all as a contraction in US demand threatens to launch a vicious spiral of declining economic activity, sinking valuations and proliferating financial instability.

The US Department of Labour reported last week that in February the total number of jobs fell for the second straight month. The news that the private sector shed more than 110,000 jobs last month prompted all but the most insistently Panglossian of economists to acknowledge that the US is in the early stages of what might be the nastiest recession in a generation.

The risk is that those liquidity and capital problems will get much worse. If, as seems likely, Americans curb their consumption spending significantly, asset values will fall further, forcing a renewed retrenchment by banks and financial institutions, a tightening credit squeeze, further declines in activity and so on.

It's surely time for the authorities to think seriously about how to halt this before it gets really unpleasant.

The Federal Reserve was somewhat late to the game last summer. Since then it has been valiantly doing what it can to avert a worsening crisis, but, as we have seen, it is not having much effect. Its short-term liquidity injections have surely helped to fend off a series of immediate funding disasters, but its attempts to stimulate through monetary policy accommodation are not getting very far.

This is not because the Fed's cuts in short-term interest rates - of which we should certainly expect more later this month - have not been driving rates lower across the whole economy.

Long-term rates, those to which consumer and corporate demand is most sensitive, are relatively low. In fact, with headline inflation in the US approaching 4.5 per cent, we are starting to see negative real interest rates on some categories of corporate loans and barely positive real rates on some consumer credit.

This represents the cheapest money to which Americans have had access since the 1980s.

The problem is that Americans are heeding the advice of Polonius in Hamlet and choosing to be neither a borrower nor a lender.

Banks don't want to lend money on collateral that is collapsing in value and companies and consumers don't much want to borrow money to buy assets, especially housing, that might be worth less than the value of their loan in six months' time.

At the root, of course, is the deteriorating US housing market. Unless and until borrowers and lenders have a high level of confidence that the value of their assets will not keep falling, they just won't risk it.

In the meantime, more borrowers will fall deeper into trouble, pushing up the foreclosure rate and intensifying the problems both in the housing market and on the balance sheets of financial institutions.

There is no certainty about when the downward spiral will end. In Japan in the 1990s it took the best part of a decade for this asset deflation to bottom out.

There are many differences between the US today and Japan then, but there is one important similarity: the Japanese crisis eased only when the government, after years of fiddling as the economy burned, finally decided to put serious financial resources to work.

The US difficulties are serious enough that the only really effective solution seems to be a massive government intervention in the battered housing market and not the piecemeal tinkering that we have seen so far.

Almost two decades ago, when a similar housing and financial crisis produced the recession of the early 1990s, the federal government wound up spending hundreds of billions of dollars bailing out the nation's savings and loan institutions.

That kind of rescue is not feasible this time because of the widespread dispersal of securitised mortgages through the global financial system. Some kind of more direct bailout is now going to be necessary. The Government could, for example, offer to lend the necessary sums at very low rates of interest to those millions of borrowers in danger of defaulting on their loans. It is only that kind of government guarantee to underpin the housing sector that will restore confidence.

It will be ugly. It involves all kinds of moral hazard and it could end up costing a fortune, further clouding an already murky fiscal outlook for the economy. In fact, the only thing it has to recommend it is that all the alternatives are catastrophically worse.

gerard.baker@thetimes.co.uk

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