WHEN Britain crashed out of the European Exchange Rate Mechanism (ERM) in September 1992, Gordon Brown, then shadow chancellor, was quick to rub salt into Prime Minister John Major and Chancellor Norman Lamont's wounds, thundering: "Colossal errors of judgment by the Prime Minister and Chancellor have betrayed the British people."

Last week there was talk on trading floors about how his words had come back to haunt him as the pound took a dramatic nosedive on Monday, following a warning from current Chancellor Alistair Darling that Britain faced its biggest economic challenge for 60 years. Sterling slumped to its lowest level against the euro since the single currency was launched in 1999. It fell to a two-year low of $1.7996 against the dollar, sealing its worst month against the US currency since Britain's ejection from the ERM.

While traders winced at their screens, stories of panic and feuding between Darling and Brown leaked from the corridors of Whitehall. Darling, whose job was rumoured to be on the line, unsuccessfully tried to claw back his comments, published in a weekend newspaper, insisting he meant to say something along the lines of Britain facing a global challenge.

Meanwhile, hopes that Brown's autumn relaunch – a package of measures intended to kick-start the property market – would put both the economy and his political career back on track were dashed as the Government looked increasingly helpless in the face of a looming recession. The package, which included a one-year stamp duty holiday for properties worth below £175,000, was quickly disregarded as "peanuts" by economists. It was further overshadowed by the latest forecast from the Organisation for Economic Co-operation and Development on Tuesday, which cut its growth expectation for the UK this year from 1.8% to 1.2% while raising its forecast for the US, the source of the sub-prime crisis, to 1.8%, leaving many asking why Britain is teetering on the edge of recession while the US appears to have side-stepped a full-blown economic breakdown.

By the time Mervyn King, governor of the Bank of England, sat down with his Monetary Policy Committee members to debate interest rates on Thursday, confidence had taken a severe knocking, and the FTSE plunged 137.6 points. It continued its falls on Friday, recording its worst weekly loss for six years.

As City watchers nervously await a slew of economic data this week, including the latest manufacturing and industrial output data, questions are being asked if the rapid decline of the pound will hammer the final nail in the economy's coffin. Will the UK slip into recession while the US escapes the storm?

Foreign exchange traders could offer little cheer last week, with many predicting the pound could fall to as low as 1.50 against the dollar in the next five years.

According to Ian Stewart, associate director of research at Deloitte, this will have a significant effect on UK consumers. "There are two consequences of the falling pound: it makes UK exports cheaper overseas but it also makes the price of products in the UK higher and therefore puts pressure on inflation."

Some retail executives have warned that the price of items such as clothing and furniture could soar by as much as 6% early next year as suppliers who negotiate their contracts in dollars are forced to pass on the costs. This could further limit the Bank of England's choices when it comes to cutting interest rates if the Consumer Prices Index, which is already 2.4% above the Bank's target, remains high.

But Stewart points out that the falling pound could also save the Chancellor's skin in the long term if it boosts UK exports. He points out that in America, the dollar, which has been in a bear market since 2002, has provided a vital source of economic growth during the liquidity crisis. "You have had a massive depreciation of the dollar. In economic terms that is very stimulative," he says.

John Hawksworth, economist at PricewaterhouseCoopers, says in the second quarter of this year exports accounted for close to 95% of US growth. In the UK he expects the fall of the pound to contribute similar much-needed growth, although he warns it will not be enough to offset the economy's other problems; for example, the falling property market and ongoing banking losses. "For years people have been complaining about the pound being too strong and limiting our exports and manufacturing," he said. "It is not going to fully offset them (other problems], but on the margin it is going to help. The fall in the dollar boosted America's exports very strongly."

He also believes retailers will have to swallow the negative consequences of sterling's depreciation, as high street sales have already been hit by the credit crunch and they will need to maintain consumer interest. "It remains to be seen whether stores could make that kind of price raise. The assumption is if the economy really is slowing down and consumers really tighten their belts then actually retailers won't be able to pass on cost increases so easily. Profit margins will be squeezed down the supply chain."

However, not everyone is so confident that Britain can emerge from the pound's collapse unharmed. Edward Menashy, chief economist at Charles Stanley stockbrokers, stresses that US exports benefited from a weak dollar because its manufacturing sector is in far better shape, particularly in the technology sphere. Britain, on the other hand, no longer has a robust manufacturing sector and relies on supplying parts, but not whole products, to foreign firms.

"America has a lot of export strengths, particularly in electronics and technology," he says. "They have something to sell that the rest of the world wants to buy, and unfortunately in the UK we don't have those industries anymore. We are part-time manufacturers for people like the Japanese. There is not an indigenous technology drive. Our biggest strength is financial services, and the financial services industry is going through an incredibly tough time. Our prime industry which could earn us a surplus with the rest of the world is on hold at this stage."

With the fall of the pound, which has lost 14.57% against the dollar since November 2007 and has been in long-term decline against the euro, adding to a mountain of other economic problems, it is now a commonly held view among economists that the UK will be extremely lucky to avoid a recession.

Stewart, of Deloitte, says: "In the UK six months ago, it would have been fairly aggressive to say the UK is going into recession. Now it's bordering on the mainstream."

Although the US has so far managed to avoid falling off the economic cliff, economists are less confident the UK will be able to do the same.

Menashy says the Americans' bold approach to life has helped them back from the brink, while the UK's characteristically reserved demeanour has let it down.

He explains: "At the start of the year, without any hesitation, the majority of people anticipated the American economy would go into recession, and in fact we didn't get it. There are two reasons for that: the Federal Reserve acted very promptly in cutting interest rates down to 2%, and secondly the Bush administration enacted a $150bn package of effective tax cuts.

"The American central bank tends to act very quickly. People say the chairman of the Federal Reserve drives a sports car whereas the other central bank leaders drive an articulated truck."

The UK Government has tried "heroically" to make changes where it can, Menashy argues, but it has been limited by a growing fiscal deficit amassed during Gordon Brown's years as Chancellor. "We have borrowed so heavily. We have fallen into the old trap of too much spending, too little saving, too much consumption and too little investment."

With inflation yet to reach its peak – it is expected to hit 5.2% or 5.3% by the autumn – economists are warning that the Bank of England will not be able to cut rates until November at the earliest. Although many, including Howard Archer of Global Insight and Richard Dingwall-Smith of Scottish Widows Investment Partnership, are pricing in several dramatic falls at the start of next year, there are those who feel this action might be too little, too late. Ahead of the MPC's meeting, committee member David Blanchflower warned that the Bank needed to act fast and to make large cuts if it wanted to stave off a deep and protracted recession. "We need to act and we probably need to act in larger amounts," he said.

Consensus among economists points to growth of just 1% in the UK next year, and the Government is widely expected to downgrade its own figures in this autumn's Pre-Budget Report.

But Menashy insists there is a silver lining to Britain's economic woes: wages. UK workers have seen their wages rise steadily throughout the decade, and so far this has continued. According to Menashy, this is because businesses have become more flexible since the collapse of the dotcom boom, employed more temporary workers and restructured so they can adapt quickly and easily to changing economic circumstances.

As a result of sustained wage increases, consumer spending has slowed, but it hasn't ground to a halt and the falls have been much smaller than many were anticipating. He argues that the UK is likely to enter a shallow recession, but if wages remain stable it won't last for long.

"Everyone has been incredibly surprised that consumer spending in the US has come down but it hasn't collapsed," he says. "Consumer spending is 70% of the total economy of the developed world."