Governments will have to pay for more bailouts, says Fund as it slashes growth forecasts and warns of global recession

We are in the worst financial crisis since Depression, says IMF

The US mortgage crisis has spiralled into "the largest financial shock since the Great Depression" and there is a one-in-four chance that it will cause a full-blown global recession, the International Monetary Fund warned yesterday.

As finance ministers and central bankers arrived in Washington to discuss ways of tackling the crisis, the IMF warned, in its twice-yearly World Economic Outlook, that governments might be forced to step in with more public bailouts of troubled banks and cash-strapped homeowners before the crisis was over.

"The financial market crisis that erupted in August 2007 has developed into the largest financial shock since the Great Depression, inflicting heavy damage on markets and institutions at the core of the financial system," it said.

After warning this week that the world's financial firms could end up shouldering $1trn (£500bn) of losses from the credit crunch, the IMF said it expected the US to experience a "mild recession", notching up GDP growth of 0.5% in 2008 and 0.6% in 2009. It expects house prices to fall by up to a further 10% before the downturn is over.

With the US sliding into such a recession, there is mounting pessimism about the ability of the rest of the world to escape unscathed. The IMF shaved its forecast for growth in the global economy by half a percentage point, to 3.7% for this year, and by 0.6% - to 3.8% - for 2009.

Although the Washington-based body expects most emerging economies to continue to grow strongly over the next two years, it admits that efforts to tackle the knock-on effects of the credit crunch could be hampered by fast-growing commodity prices. "Inflation has picked up around the globe, mainly reflecting sharp increases in food and energy prices," it said.

In the US, President Bush has already signed off a $150bn tax rebate package to kick-start the US economy, and the Federal Reserve last month backed an extraordinary emergency buyout of the investment bank Bear Stearns.

However, the IMF said more taxpayers' cash may still need to be spent to unblock the markets. "Given the serious risks coming from sustained financial market dislocations, the recent legislation to provide additional fiscal support for an economy under stress is fully justified, and room may need to be found for some additional support for housing and financial markets."

Simon Johnson, IMF research director, presenting the report in Washington, described such bailouts as an essential "third line of defence", after interest rate and tax cuts, for governments struggling to prevent a deep recession.

He said the main risk to the global economy over the next year was the emergence of a vicious circle, as house prices continued to fall, dealing a fresh blow to the world's banks, and creating a damaging feedback loop.

"Sentiment in financial markets has improved in recent weeks since the Federal Reserve's strong actions with regard to investment banks. But we have seen how strains in markets can quickly become reinforcing, and the possibility of a negative spiral or 'financial decelerator' remains a possibility," he warned.

The IMF's downbeat analysis creates a gloomy backdrop for policymakers arriving in Washington to discuss ways of easing the credit squeeze. Such is the concern about problems in the financial markets that a range of radical options is on the table. These include greater disclosure of losses on sub-prime assets by banks; firmer regulation of credit-rating agencies, and - more controversially - plans for taking some of the risky mortgage-backed assets at the heart of the crisis on to government balance sheets. Alistair Darling, the chancellor, is calling for a detailed plan to be agreed over the weekend.

The IMF backed more comprehensive disclosure by banks. "We fully support the move towards greater disclosure," Johnson said. "We think that marking to market [rating assets on current market values, not book values] and continuing to recognise losses is an important part of how the financial system operates."

The US Federal Reserve has cut US interest rates by a hefty 3 percentage points to 2.25% since the crisis began, in an attempt to restore confidence and turn the credit taps back on. The IMF welcomed the Fed's approach but said it would not be enough to prevent recession.

"Adverse financial conditions are likely to have a continuing negative impact on activity in the United States, notwithstanding the Federal Reserve's strong response," it said. "The United States remains plagued by profound errors in risk management."

The value of the dollar has plunged to record lows in the past year as the outlook for the US economy has darkened, but the IMF said the greenback still "remains somewhat on the strong side".

No bounce after the hard landing

Alistair Darling's forecast that Britain will bounce back from the credit crunch by next year now looks hopelessly optimistic, according to an authoritative assessment by the International Monetary Fund.

Just a month ago, in the budget, the Treasury had pencilled in 2% GDP growth this year and 2.5% in 2009 as the economy recovers, but yesterday the Washington-based IMF predicted far weaker growth of 1.6% both years.

The chancellor has said repeatedly that Britain is "better placed" to weather the storm because of its low unemployment and flexible labour market, but the IMF calculates that the housing market is overvalued by up to 30% and faces a damaging correction.

"The housing market is going to be a drag on the economy," said Charles Collyns, a senior IMF economist. "We do see house prices softening already, and we see potential that the housing correction will continue, with an impact on consumption. We also see the UK being affected by the tightening of the financial constraints related to the turmoil in the financial markets."

He added that the knock-on effects of weak growth in the US and the eurozone would also depress growth.

House prices fell 2.5% last month, Halifax said, and the IMF says the wider economy will be hit hard as overstretched banks repair balance sheets and borrowers face tighter loan conditions and higher interest rates. In January, when it last updated forecasts, the IMF was expecting expansion of 2.4% in 2009, but the longer the credit crunch continues, the more threatened the UK economy has become. Darling said yesterday that the downgrade was "not surprising" and the economy was "extremely strong".

Heather Stewart