Three years ago Time magazine carried an article by James Cramer, the founder of TheStreet.com, an online magazine fully dedicated to the worship of mammon. Extolling the virtues of a life dedicated to buying and selling shares from home, it was called "Yeah, Day Traders!" Cramer's message was simple. Forget teaching, forget tilling the land, forget making trucks or mending bones; instead make a living from speculation. There had, the article insisted, never been a better time "to trade for a living".

In his splendid book on the triumph of extreme capitalism*, Thomas Frank called 1999 the summer of corporate love, and he was spot on. Just as in 1967, the promise was of liberation from the straight world of the past; the difference was that the drug of choice was not LSD but money. And the gurus of the revolution were not the Beatles and the Stones, but men like Cramer and James Glassman, who predicted that the Dow Jones industrial average would not stop at 10,000 but rise inexorably to 36,000. A suitable epitaph for the summer of corporate love would be John Lennon's for the Beatles when they split up three years after Sgt Pepper: "The dream is over."

Today the talk is not of when the Dow will hit 36,000 but how low it will go. Today, a magazine that used the headline "Yeah, Day Traders!" would be in danger of being torched by the small army of investors who have seen the value of their portfolios shrivel since the bubble burst in the spring of 2000. Today, the issue is whether the price of collective market insanity will be a serious global recession or, even worse, a full-blown slump.

There is an army of pundits out there willing to say that there is little to worry about. Policy makers everywhere are oozing reassurance, intoning the mantra that the economic vibes are good. Lawrence Lindsey, George Bush's economic adviser, was at it in the Financial Times yesterday, insisting that a recession in the US was "unlikely".

In reality, of course, nobody knows for sure what is going to happen. Financial analysts have their charts which are supposed to be able to predict the future from the past, and these now spell trouble. Economists who look at the hard economic data say that cheaper money and higher spending means things are getting better. But both presuppose that economics is a science rather than a modern form of alchemy, and that the practitioners in its black arts are anything more than highly-paid witch doctors. The only theory that is really relevant to the stock market is chaos theory. The recent history of the dollar is a case in point. For at least the past five years, the strength of the US currency has been eating into corporate profitability and contributing to a record trade deficit. Markets knew that the dollar was overvalued, but kept on buying it regardless. Over the past two months, the mood has changed and the dollar has fallen by 14% against the euro, breaking through the one-for-one parity level yesterday for the first time in more than two years. When will the fall be arrested? Who knows? On some estimates, the dollar is still 30% overvalued, but a rapid fall of that size would feed back into the equity markets, with foreign investors rushing for the door.

All of which explains why policymakers are a lot more concerned about the recent downward spasm in share prices than they are letting on. The sharp fall in American consumer confidence reported last Friday was a clear indication that the public mood has been affected by the declines on Wall Street triggered by the $3.8bn accounting fraud at WorldCom. Alan Greenspan, chairman of the Federal Reserve, America's central bank, is giving testimony to Congress today but his words will be less important than the Fed's actions when it meets next month to set interest rates.

Greenspan's real fear is that the US economy will become locked in a downward spiral in which falling share prices lead to weak consumption, which in turn puts pressure on company profits and - eventually - the financial system itself. Asset prices would collapse and corporations be forced to slash prices in order to generate cash flow, leading to a period of deflation in which lower interest rates failed to stimulate growth. It could never happen, say the optimists. In fact, it already has - in the world's second largest economy, Japan. There, the country has had four recessions since its bubble burst at the end of the 1980s. Prices are falling, consumers are hoarding cash; it would take but one more shove to push the banks over the edge into systemic crisis. Greenspan has been studying a voluminous report he ordered into the Japanese experience; that's how worried he is.

The best that can be hoped for is that there are no more stories of boardroom wrongdoing over the coming weeks, and that some better (and honest) figures from some of the titans of corporate America produce a rapid recovery in share prices, which then boosts consumer spending. This would not provide a cure for the economy's ills, which are caused by excessive hi-tech investment and excessive borrowing during the bubble years, but it would at least buy Greenspan some time.

F ar more worrying would be a continuation of the falls in share prices over the next couple of weeks. In those circumstances, the Fed would then come under strong pressure to cut interest rates at its August meeting, and would almost certainly bow to it. There is, however, no guarantee that it would be effective in restoring confidence. Why? Firstly, it would be a small cut of only 0.25 percentage points from the already low level of 1.75%. Secondly, it might be counter-productive, seen as a sign that the Fed was panicking (which it would be). Finally, the relevant level of interest rates is the one being paid by companies and consumers on their loans. These have not been coming down nearly quickly enough to prevent financial distress.

The underlying problem is that since the mid-1990s, share prices are up by 200% but corporate profits - as measured by sober government statisticians rather than dodgy auditors - have risen by 40%. It is conceivable that Greenspan would have to cut, cut and cut again before Wall Street responded. Even then (and assuming there is no invasion of Iraq to complicate matters), there is a risk that the easing of policy will simply lead to a re-run of this year - a short-lived burst of euphoria followed by the realization that companies cannot produce the earnings expected of them. Greenspan and Bush would then be in an even worse quandary than they are now, having used up nearly all the shots in their locker. Meanwhile, Europe and Japan - heavily dependent on a US recovery to keep their economies ticking over - would be faced with the prospect of deep, prolonged recession.

If this sounds gloomy, that's because it is. It would be the most critical moment for the global economy since the 1930s. There would, however, be one silver lining: people would ask how we got into this mess in the first place. The answer is that policy makers, dazzled by Cramer, Glassman and their friends in the financial markets, deliberately removed the brake pedal from global capitalism. And, as any engineer knows, the brake pedal is what allows the machine to travel safely at speed. Without it there are only two speeds - dangerously fast and dead slow.

*One Market Under God, Thomas Frank (Secker and Warburg)

© Guardian Newspapers Limited 2002

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