Whether it's front runner Barack Obama or outsider John McCain who makes it to the White House when America goes to the polls tomorrow, the first briefing the new president gets on the economy from the US treasury and the Federal Reserve will be a sombre affair. Rarely, if ever, in the postwar period has a new chief executive faced a more challenging baptism.

On the plus side, circumstances do not look quite so bleak as they did a month ago, when there was justifiable concern that the entire global financial system was on the point of collapse. One positive result from the mayhem that followed the collapse of Lehman Brothers was that it forced policymakers around the world to act quickly, decisively and collectively to halt the slide into the abyss.

Japan's decision last week to force down the value of the yen was partly driven by the need to help the big exporters on whom the economy relies, but it was also intended to boost capital flows into the US through the sale of yen for dollars. That was one reason Wall Street rallied so strongly.

Policy action has not been confined to recapitalising the banks and injecting large dollops of cheap money into financial markets in the hope that it will persuade banks to start lending to one another once again.

Monetary policy is being eased everywhere, with the expectation that the Fed will join Japan in having a policy rate below 1% by the end of the year. Rates in the UK are also set to tumble: Roger Bootle at Capital Economics believes they could be cut to 1% in 2009 as the Bank of England tries to jump-start the economy. Rates have never been lower than 2% in the postwar era.

Deepest recession

Central banks will be able to use easing inflationary pressure to justify these rock-bottom interest rates. Oil prices are less than half their peak of early July, and other commodity prices are also down sharply as global demand weakens. The new US president will be hoping that the boost to real incomes from cheaper gasoline prices provides a boost to confidence and spending.

That, though, is just about the extent of the good news. The bad news for Obama or McCain is that the US and the other members of the G7 industrialised nations face the deepest recession since the 1930s; that the crisis has not gone away, merely been pushed - perhaps temporarily - from the core of the system to the emerging markets; and that the dominant financial model of the past decade and more is bust.

Part of the problem, as Stephen Lewis of Monument Securities has noted, is that it has taken far too long for policymakers to understand that they cannot shove the genie back into the bottle, and as a result the downturn in prospect for 2009 and 2010 will be much deeper than it ought to have been.

"If the G7 had recognised at an early stage, say a year ago, that the financial capitalism model was irretrievably broken, they might have managed the transition to a new economic model at less cost than they have subsequently incurred," Lewis says. "They might have dissolved the investment banks and the toxic products they had created before a negative feedback loop from the economy to the financial sector was established."

That "negative feedback loop" works as follows. The financial sector goes haywire during the boom years, developing business models that work only in the good times. As the Bank of England noted in last week's financial stability report, the British banking system was lending £750bn more than it was taking in deposits, covering the gap by raising money in the wholesale markets and betting that the good times would go on for ever. When the bust arrives, the model collapses and the financial sector retrenches. It severely rations credit, with the result that house prices fall, businesses go bust and people lose their jobs. The losses of the financial sector mount, leaving them short of capital and even more unwilling to lend.

Everything that policymakers have done over the past month - from nationalisation of banks to cuts in interest rates - has been designed to break this vicious circle. Their efforts have worked to the extent that money market rates have started to fall, but this is a skirmish in a much longer war.

In the US, for example, the official interest rate has come down from 5.25% in the summer to 1%, yet mortgage rates have not fallen as much. The 30-year home loan rate has declined by a little over half a percentage point, a tiny reduction in the context of the biggest housing boom-bust in American history. Mortgage rates at their current levels mean the real estate market will remain in crisis, with knock-on effects for all those under-performing mortgage-backed securities held by the banks.

Crowding out

Policymakers also need to be aware of the dangers of what economists term "crowding out". This is where a big increase in borrowing by governments makes it more expensive for the private sector to obtain funds. In the context of a global economy, there is the added dimension of sovereign "crowding out", whereby the need to bolster the countries at the core of the global financial system leads to a dearth of funds for weaker countries. There is evidence of both these phenomena: upward pressure on non-investment corporate bond yields and in the problems faced by Iceland, Hungary, Ukraine and other emerging economies.

Equally, the fall in the cost of crude may be good news for western consumers but it is not so hot for the oil-exporting countries, many of which are hardly models of stable democracies. A further halving of the oil price to about $30 a barrel could quite easily lead to severe political unrest, perhaps even revolution, resulting in restrictions in supply and a surge in crude prices to the peak levels reached earlier this year.

The message for Obama or McCain is simple. Things have moved on apace even from where they were in the summer when only one of the 17 agenda items for the new president listed by the Associated Press mentioned the credit crisis. So far, America's downturn has been shallow, but the squeeze on consumer incomes and the deteriorating labour markets mean there is worse to come. The US will be in recession in 2009, as will the eurozone, Japan and Britain, and for the G7 as a whole this is likely to be the worst downturn since the second world war. The big developing countries, China in particular, cannot be immune from the problems in the west; given the export-dominated nature of these economies it was always fanciful to suppose that they could decouple themselves.

All of which suggests that the new president faces an economic challenge as testing as any since Roosevelt arrived in the White House in 1933. The good news is that even using the most pessimistic assumptions it is hard to see a peak-to-trough decline in US GDP of anything like the sort suffered in the Great Depression, when the economy contracted by 25%.

The bad news for tomorrow's victor is that FDR arrived after the worst of the slump was over, rather than just as it began. Even if everything goes according to plan and there are no policy errors, America will still have a recession every bit as costly as those in the 1970s and 1980s.

larry.elliott@theguardian.com