When the boat stops sinking, don't stop bailing

Sometimes, progress is its own obstacle to achieving a solution. Consider this illustration: a bunch of fishermen head out one winter morning in an old boat - call it the Andrea Gail - looking to catch big-game swordfish. Technology and lady luck are on their side and pretty soon the hold is stuffed with whoppers. But the weather is against them and as the sea rises, the boat begins to founder. Realising their predicament, the fishermen start tossing out their trophies, and pretty soon the freezing water stops pouring in. The men take heart. Maybe they might not sink after all.

But as their panic subsides, the accusations ensue. Whose idea was it to come out here in the first place, they ask? They grumble about the skipper, the seaworthiness of his vessel and his decision to risk the weather. The boat's not the problem, the skipper shoots back, why did you overload the hold? Someone starts pointing the finger at the guy who caught the biggest fish. Clearly, he was to blame.

What the fishermen don't realise is that they have been cast in an allegory loosely based on the 2000 film The Perfect Storm. As they argue, the water slowly rises again in the boat and they slip beneath the icy waves. We see George Clooney going down with the vessel as it sinks into the depths. The moral of the story: don't stop bailing. The problem facing the global economy right now, economists warn, is that governments and the public mistake progress for remedy, and that they allow politics to hijack recovery efforts.

The recent rally in stock markets, for example, has prompted many to wonder if the global economy has turned the corner. Others dismiss the rally as a false dawn, a bear-market rally or a "dead-cat bounce". It doesn't matter. Investors try to predict price movements based on trends in profitability. The economy affects profitability, therefore markets are roughly correlated with the economy. But markets are not weathervanes. They go up and down, whether the economy rises or falls.

And the global economy is still getting worse, economists say. Leading the charge is the US, which is caught in a vicious circle of lower profits, job losses, reduced spending and falling asset prices. Trade-dependent economies in Asia and the Gulf are suffering whiplash thanks to sinking global commerce and diminishing appetite for risk among global investors. The good news is that efforts by the US government and others around the world to shore up the economy are gaining traction. As this column noted last week, credit markets are thawing and it has become clear that there are funds available, but only for borrowers that investors consider very low risk, such as the US government or the Government of Abu Dhabi.

What is driving stocks isn't the likelihood of a recovery but what the efforts to achieve one mean for asset prices. For those who believe the US government will manage to print enough money to inflate its way out of recession, stocks are a good hedge, particularly those denominated in currencies other than the US dollar. For those who, like most economists, think deflation is still a bigger risk as banks, companies and consumers are forced to save up more money than the US government is printing or borrowing, the safety of bonds is more alluring.

How fast the US and the rest of the world recover, though, depends in a large part on how governments manage this so-called deleveraging. Washington's efforts to bail out the banking system have finally managed to combine the necessary ingredients. There is at last a plan to relieve banks of the depreciating assets undermining their capital base. This complements earlier efforts to replenish banks' dwindling capital with taxpayer funds.

But the new Public-Private Investment Programme (PPIP), announced last month, lacks an important compulsory component, economists say. The danger now is that banks hold on to their toxic assets at inflated values, only grudgingly writing them down, but never regaining health. The administration of Barack Obama, the US president, is submitting banks to stress tests to determine which will be allowed to shore up their capital with what's left of the previous administration's US$700 billion (Dh2.57 trillion) bailout funds.

Economists say its worst-case scenarios are too optimistic, enabling insolvent banks to continue receiving taxpayer funds when they should be either allowed to fail or be taken over. That will dissuade banks from selling bad assets to the government, since doing so would force them to take more write-offs and potentially push them under water. So will the latest decision by the Financial Accounting Standards Board to ease requirements that banks mark their assets to the latest market price.

One can argue which is cheaper for the taxpayer: buying toxic assets for cents on the dollar in the hope they eventually become profitable, or buying discounted equity in banks clogged with toxic assets in the hope those banks return to health. Whatever it does, economists say Washington is going to need more cash to do it. But with a backlash against bankers and executive bonuses, economists fear the US Congress will refuse to approve additional funds.

Similarly, economists say Mr Obama's $787bn fiscal stimulus plan won't be enough. He's going to need another. Congress narrowly passed the original package amid political objections to rising US indebtedness and the higher taxes needed to finance it. Europe's own reluctance to borrow and spend also threatens to dilute the impact of spending in Washington and elsewhere, economists warn. If fiscal spending outside of Europe works, European exports will benefit, economists argue.

But if Europe doesn't stimulate its own demand, it won't be providing a reciprocal source of demand for its trading partners. Without its own version of the PPIP, Europe stands to get a free bank bailout from Washington as US purchases set a price for toxic assets held by European banks. When it comes to bailing out the global economy, therefore, all hands need to be on deck. warnold@thenational.ae