In 2007 and 2008, all the talk was of the dreaded 'R' word. Recession was looming ominously in the UK; we could feel it in the air. Four years later and the focus has shifted from the letter 'R' to the letter 'D', which of course, stands for deficit, or debt.

Without doubt, colossal sovereign debts are shaping the future of the global economy at present. Look around and there are endless examples of countries that are up to their eyeballs in debt — or even teetering on the edge of bankruptcy. It's serious. Very serious. The colour of the markets is red.

By the time you're reading this, Greece may well have defaulted. If it hasn't, it's predicted to happen soon. The talk has been of a potential multitrillion pound boost to the European Financial Stability Facility, which would limit the harmful effects in the event of a Greek default.

A shoring up of the Eurozone via such a fund is imperative, as a Greek default would potentially trigger a massive domino effect, with Italy potentially the second domino to fall. Reflecting this potential for transmission, in September the ratings agency, Standard & Poor's, downgraded Italy's sovereign credit rating. The problem is that if a country such as Italy succumbs to its debts, it is, in the words of one analyst, 'too big to bail'.

If Italy goes down with Greece, the Eurozone would implode. And if this happens, the global economy would be devastated, potentially for many years to come.

Meanwhile, the eleventh hour wrangling during the summer between Democrats and Republicans over the US economy's own debt level says all you need to know about the chaos that can arise from excessive deficits. As a destabilizer of global markets, they are second to none. In 2009, economies around the world, in the words of one observer, merely "kicked the can down the road" in a spate of refinancing, write-downs and bail-outs. They've now caught up with the can and have to face their deficits all over again. And this time they can't defer until another day.

Times are changing

What the US debt drama also tells you is that the world we occupy now is different to the world we occupied in 2007. For America to have come close to defaulting and to have subsequently have had its credit rating downgraded reflects just how fundamentally, in recent years, the global economy has changed.The safe havens of the past are now a thing of the past. And not only do many of the world's biggest economies have huge deficits, they also have weak economies, which, in a vicious circle, are further weakened by deficit reduction plans.

In the black, just

Back at home in the UK we have our own mammoth debt mountain to reduce. The UK economy has stagnated over the past nine months and is still faced with no end of severe headwinds (see box, right). In Q2, according to figures released at the end of July, the UK economy grew by 0.2%. This followed growth of 0.5% in Q1 and -0.5% in Q4 2010.Yes, we were in the black during the second quarter, but only just.

In response to the weak economy, the Bank of England downgraded its 2011 growth forecast in its quarterly inflation report in August to 1.5%. Around the same time, the International Monetary Fund (IMF) expressed concern that the slowdown in the UK economy was becoming entrenched. Its fears are not misplaced. Alongside more tax cuts, the IMF even suggested we revisit QE (quantitative easing) if things deteriorate further. The minutes of the Bank of England's September Monetary Policy Meeting showed that it's not alone, as QE was once again on the cards among our own policymakers.

As the monetary stimulus of last resort, the fact that QE is back in the frame says a lot about where the economy is at.

There's certainly no guarantee we won't slip into the red during Q3. Follow that up with a negative Q4 and we're technically back in recession.

Temporary setback?

But maybe all this talk of a Double Dip is really a little OTT? For example, when it released the Q2 GDP figure, the Office of National Statistics (ONS) observed that the weak growth in Q2 will partly have been due to one-off factors including the Japanese Tsunami, spate of Bank Holidays in April and May, Royal Wedding and even the first phase of Olympic ticket sales. Together, the argument goes, these factors will genuinely have skewed GDP over that period. In their absence, estimates the ONS, GDP would in fact have been half a percent higher, so 0.7% as opposed to 0.2%. In other words, the economy would have fared not badly at all given the challenges we are still facing. And maybe we shouldn't be so hard on ourselves anyway. These are very turbulent times but at least we are moving in the right direction. The UK is growing in a low - or even nongrowth world.

Catch 22

So, when can we expect the economy to start picking up speed? It could be a while yet. One big problem for businesses remains consumers, who continue to 'deleverage', namely pay down debt rather than spend. Until this deleveraging stops and people start spending again, thereby injecting money into the economy, it's hard to see how the economy will show strong sustainable growth.

The Catch 22, of course, is that people need to see an improvement in the economy before they start spending, but an improvement in the economy is contingent upon their spending in the first place.

Banks not lending

Another big problem for business — and therefore the UK economy as a whole — is the banks, which remain reluctant to lend. They are particularly coy when it comes to SMEs, which are the engine room of the UK economy. To grow, SMEs need to be able to invest but to invest they need the funds, which just aren't forthcoming. Until the banks start lending again, and materially rather than as a gesture, it is hard to see how the economy will show robust growth.

Interest rates

What is certain is that for the economy to finally start spluttering back into life, interest rates will have to remain low. If high inflation forces the Monetary Policy Committee to hike Bank Rate prematurely, the impact on businesses could be severe and any recovery nipped in the bud. Thankfully, though, the consensus is that rates will be unlikely to rise before late 2012, maybe even 2013. At some point, of course, rates will have to rise. When they do, it's imperative that the up-cycle is managed perfectly by the Bank of England. Too much too soon and the recovery could once again be jeopardized.

All in all, the Bank of England will have its work cut out during the rest of the year, 2012 and beyond. Admittedly, the economy isn't growing with any real oomph right now but at least it is growing. If the Government can convince the banks to start lending that little bit more, if inflation slowly starts to come down giving people more disposable income and if unemployment doesn't rise as high as had previously been thought, we may just exit the current quandary in one piece.

Ten headwinds hitting the UK economy

1. High inflation, which is reducing people's disposable incomes

2. Low consumer confidence

3. Consumers focused on paying down debt

4. Weak property market

5. Rising company insolvencies

6. Increased taxes

7. Rising unemployment as public sector job cuts kick in

8. Structural impact of deficit reduction plan on economy

9. Key export markets — Europe and the US — on the rack

10. High bank exposure to bad debt in Europe

Michael Davis, Managing Partner

E mdavis@hwfisher.co.uk