By Dr David Clark

Are we heading for a Great Depression-like downturn or have we now seen the worst of the global credit crisis?

A sober examination of the latest information follows.

The main arguments in support of the proposition that we have not seen the worst of the current financial crisis are:

• There are likely to be more disclosures of previously unexpected financial problems in major banks and other institutions.
• The US Federal Reserve's rescue operations - such as that of Bear Stearns - have merely added to "moral hazard". In other words, market players now believe the Fed will bail out any future defaulters, creating a false and dangerous optimism that we have seen the worst of the crisis.
• A dangerous feedback mechanism may be developing between US financial markets and the real economy.

In other words, uncertainty about the size of and distribution of US bank losses, reduced capital buffers, and the general reduction in credit creation brought about by the slowing in the economy, are all likely to send the US economy into a further downwards slide, the pessimists argue.

• What the IMF calls "dangerous liquidity cycles" - which come about through the interaction of market and funding liquidity - may further worsen the situation.

In other words, market illiquidity (when financial assets can only be traded at a substantial premium or discount) together with funding illiquidity (when a solvent financial institution or company can't borrow enough funds to meet its obligations when they fall due), may feed off each other, creating a double-whammy hit to the already shaky financial system.

On the other hand, the less pessimistic reply:

• The rescue operations of the Federal Reserve and supporting actions by other central banks have shown that this crisis is very different to that of the 1930s, when such banks either did not exist or sat on their hands.
• Commitments by the governments of the major economies to co-ordinate their policy and regulatory responses are very different to the 1930s, when a "beggar-my-neighbour" attitude prevailed.
• The banking systems of the major economies are much healthier and better regulated than the 1930s.
• World trade and commodity prices are not collapsing, as they did in the 1930s, and both will continue to be under-pinned by continuing economic expansion in the emerging economies.

Thus, the major economies are very unlikely to go into a sustained, economic depression, with sharp rises in unemployment and sustained collapses in consumer demand and industrial production.

Closer to home, our financial system is very healthy. For example, a UBS study estimates that our banks will only be forced to write off about 0.3 per cent of their assets over 2007-08, compared with the 2.7 per cent write off at the peak of the early 1990s recession.

Indeed, our financial system is widely recognised as one the world's healthiest.

Our corporate debt is also very far from a crisis situation. For example, a Constellation Capital study found that our companies' ability to service interest payments is currently three times greater than in the early 1990s.

In short, the current situation is very different to that of the early 1930s.

As for the media attention-seeking scare-mongers, who suggest that the serious US problems are about to be replicated Down Under, the following passage from a recent speech by the Governor of the Reserve Bank on the topic is a sufficient riposte:

"The Australian financial system remains in good shape, as set out in the Reserve Bank's recent Financial Stability Review. Nothing said here should be taken as carrying any implication to the contrary."

Dr David Clark taught Business Economics at the University of NSW for 35 years, was an AFR and Personal Investor columnist for over a decade, and is now an investor educator. The views expressed are those of David Clark's, not necessarily those of Vanguard's.