THE financial crisis in many developed countries means they will experience sharp recession followed by prolonged weakness. Australia, on the other hand, will experience a relatively moderate downturn, which will be followed by lingering weakness as falls in business investment constrain growth.

Currently, investment remains firm as we finish the last round of projects across the board, but the next round of projects has been slashed and business investment will fall sharply over the next two years.

Initiated by last year’s rise in interest rates, but now driven by the collapse in confidence, both consumers and businesses have gone into precautionary saving mode. Households aren’t spending for fear of unemployment and businesses are cutting costs.

Fear of unemployment is self-fulfilling. We will probably see the unemployment rate approaching seven per cent some time next year. Sure, the global financial crisis has driven a collapse in equity markets and the credit squeeze, but in terms of the real economy, we’re shooting ourselves in the foot.

But the downturn in Australia won’t be nearly as bad as other overseas developed economies. The financial crisis is overseas, where a collapse in asset values has required banks to write off substantial bad debts causing a loss of bank equity. Many developed western economies such as the US, the UK, Germany and Japan are experiencing sharp recessions with the prospect of protracted weakness as they refinance their banking systems and work their way through the millstone of bad debt.

Australia would normally see a quick rebound as lower interest rates pump income into the mortgage belt, confidence recovers, undersupplied housing markets rebound and households start to spend again, particularly with the government cash injections. But this time, weak exports, the fall in commodity prices and the shock to demand have hit the financial viability of projects.

Meanwhile, the continuing credit squeeze and constraints on equity funding mean there is little finance available for new projects. And that has slaughtered business investment. Property development has already been hit. Minerals investment will also fall sharply – BIS Shrapnel’s current forecast is for a fall of 50 per cent, with the possibility it could be worse.

Investment, and particularly construction, is the primary growth driver for the economy. Fortunately, there are factors offsetting the weakness of business investment. The ‘Ruddbank’ can help to put the finger in the dyke to contain the leakage of overseas bank funding. But that is just a stopgap – the real need is for equity finance.

Government infrastructure spending has a much greater role to play in filling the gap left by the fall in business investment. The question is how long will it take to get these projects off the ground and how determined the government will be in the face of an escalating deficit?

Meanwhile, we’ve seen the bottom of the residential cycle. The next stage is an upswing, probably next year, building momentum into what will become a boom.

The short-term weakening of the economy has been self-inflicted. Australia’s short-term prospects will depend on how strong the downturn caused by precautionary saving and the credit squeeze will be. But the end of the credit squeeze won’t solve all our problems. Instead, we need to look beyond the current weakness to understand the factors that will shape the economy over the next five years.

The result is that Australia will experience a moderate downturn followed by protracted weakness as reduced investment constrains growth. Whether or not there is a technical ‘recession’ is not the point to get hung up on, but this is a substantial downturn.

Businesses need to survive the current shock but they also need to look beyond it and understand where they fit into the changing structure of the economy, particularly the shift away from imports and back to domestic production which will be underwritten by the lower Australian dollar.

The strength of the economy over the next five years will depend on the extent to which strong housing and government spending on infrastructure will offset falling business investment.