The International Monetary Fund (IMF), which supervises the world financial system, says an economic slowdown is likely due to the global credit crunch.
Turbulence in the markets could hit us all
The IMF warned in its global stability report that the "downside risks [to growth] have increased significantly".
IMF Managing Director Rodrigo Rato said that the biggest impact of the crisis will be on the US economy in 2008.
His comments came soon after a former Federal Reserve chairman said there was a 50% chance of a recession in the US.
"We're heading towards a slowdown," Alan Greenspan said on Sunday. "Whether that actually leads to a recession is dependent on things we can't forecast at this moment."
World growth slowdown
The IMF said that even if credit markets recover, the turbulence may have "far reaching and significant" consequences.
While world economic growth should remain high next year- driven by the buoyant Asian economies - it will be lower than the levels of 2006 and 2007, said Mr Rato.
The longer financial markets remain in crisis, the greater the risk of a further slowdown, he added - and the strong euro could be a particular problem.
The IMF will publish its world economic forecast next month, but some independent forecasters have suggested that the US economy might only grow by 1% to 1.5% next year, half its current rate, while the UK could slow to between 1.5% and 2%, compared to the 2.8% expected this year.
The IMF report says that the collapse of credit markets, and concerns about the location and size of potential losses, "has led to disruptions in some money markets and funding difficulties for a number of financial institutions".
And it warns that despite the "extraordinary" injection of cash by central banks to ensure the orderly functioning of markets, "the potential consequences of this episode should not be underestimated and the adjustment process is likely to be protracted".
What should be done?
The report says that although it is too early to draw definitive policy conclusions about how to prevent future crises of this type, there are several key lessons:
- Uncertainty and lack of information: Financial markets have seized up partly because they lack information about the underlying risks of complicated financial instruments. Greater transparency is needed if markets are to function properly in pricing risk.
- Unintended consequences of globalisation: While financial innovation, such as "securitisation" of risky mortgage lending, has spread risk more evenly around the financial system, it has also made more institutions vulnerable to those risks.
- Role of credit agencies: Banks have relied on rating agencies to tell them how risky their involvement in these exotic new financial instruments might be, but they may not have been up to the job.
The IMF says that "policymakers now face a delicate task" of tightening up on regulations while being mindful that "households and firms have benefited greatly from financial innovation and sold growth and financial stability of recent years."
The issue is likely to dominate the IMF's annual meeting in Washington next month, with France and the US clashing on whether too much regulation of the world financial system would discourage financial innovation.
The US faces its own issues in this area - as the lax lending practices of mortgage companies, who were only lightly regulated by the US Federal Reserve, was a key factor contributing to the crisis.
The Bush administration is now discussing how to tighten up such regulations, amid predictions of up to 500,000 foreclosures on sub-prime mortgages next year.