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A year after the global financial crisis dropped the world economy into free fall, it's starting to stabilise and there are growing signs of recovery in the United States.

Even so, the developed world will be feeling the debilitating after-effects of the crisis for at least the next decade.

Interest rates, taxes and unemployment will be higher than before and economic growth and consumption weaker as the legacy of the crisis is slowly and painfully overcome.

With luck, Australia's economy will escape most of the backwash because of our growing orientation towards China and the rest of developing Asia.

World financial markets have calmed down a lot, so risk premiums – "spreads" – have narrowed in many markets and the issue of corporate bonds has resumed. Barring another financial shock, the crisis is abating.

The US economy entered recession at the beginning of last year, but the panic that followed the collapse of the Lehman Brothers investment bank last September plunged the US and the global economy into free fall.

After a remarkable fall-off in world trade, there were huge contractions in production in the December and March quarters, not just in the US but in all major developed economies.

In the US, the rate of contraction slowed in the June quarter and there are now clear signs that gross domestic product has begun expanding – though the same can't be said for Britain and Europe.

But production is one thing, unemployment another. The unemployment rate has reached 9.7 per cent in the US (and 9.5 per cent in Europe), and production growth won't be sufficiently strong to stop it going a couple of points higher and staying there for two or three years before it begins a painfully slow descent.

Normally, economies grow strongly in the recovery from a recession, but that's not likely this time. Why not? Because of the wreckage from the financial crisis that precipitated the global recession.

Financial crises leave businesses, banks and – particularly in the US – households with their balance sheets in disrepair. That is, with their debts too high relative to the newly reduced value of their assets.

Repairing balance sheets, by liquidating assets and cutting spending so as to pay down debts, is always a painfully slow process. And business doesn't fully return to normal until that process is complete.

Two particular problems are expected to keep growth in the US and the other major advanced economies surprisingly slow for at least the next decade.

The first is the need for fundamental changes in the structure of the financial system to correct the deficiencies revealed by the crisis and to prevent any recurrence of a crisis.

Much of this change will focus on banks. As well as the need to clean up their balance sheets by getting rid of the toxic assets – bad investments – they ended up with, rating agencies and sharemarkets are demanding a move to more conservative funding arrangements.

Banks need higher proportions of capital, assets that are more liquid and liabilities that are longer term.

Each of these changes will make the banks safer – less likely to collapse – but each also increases banks' costs. So the structural change being brought about will increase the price of financial intermediation (which is what banks do: act as intermediaries between lenders and borrowers, savers and investors).

This, in turn, will cause the general level of interest rates to be higher than otherwise and, certainly, higher than in the years leading up to the crisis. Structurally higher interest rates lead to lower levels of investment in physical capital which, in time, leads to lower levels of the stock of physical capital than would have been the case.

This, in turn, leads to slower growth in output per person and thus material standards of living. The second problem is the huge levels of public debt the US and most other major advanced countries find themselves with – levels approaching the annual value of gross domestic product.

These countries began the crisis with budget deficits and already high levels of public debt, but then added heavy borrowing to cover record fiscal stimulus packages and the bailout of many banks and other businesses.

This problem has arisen when these governments were already facing major budgetary pressures from the ageing of the population and blow-outs in the costs of their unfunded public pension schemes.

The anxieties of government bond markets – reflected in rising long-term interest rates – will impose irresistible pressure on governments to reduce budget deficits and get debt levels under control.

This will leave them with little scope for new spending on worthy projects and, indeed, facing continuous pressure for cuts in spending. But higher taxes are a more predictable response than swingeing cuts in spending.

Either way, the stance of budgetary policy is likely to be somewhat contractionary, meaning it will act as a continuing drag on economic growth. In the US, all this will be happening at a time when the household sector is "deleveraging" – getting on top of its debts.

This means consumer spending will contribute little to economic growth. It also means the US consumer will no longer be the "importer of last resort", effectively exporting growth to the rest of the world. So much for the dismal prospects for the major developed economies.

Most of their domestic problems – overextended banks and households, high levels of public debt – don't apply to us. Their greatest effect on us will come through higher world long-term interest rates and reduced demand for our exports.

But an ever-growing proportion of our exports goes to China and the other developing countries of Asia. The challenge for them is to reorient their economies away from export-led growth and towards domestic demand from infrastructure investment and consumer spending.

This won't be easy, but the Chinese authorities face powerful incentives to make sure it happens. So far, a combination of good management and good luck has minimised the damage to us from the global crisis.

With a bit more of both, our prospects will remain a lot brighter than those for most of the developed countries.


Ross Gittins is the Herald's Economics Editor.