The end to the current crisis seems far away. Economic risks are rising, rather than stabilizing or decreasing. What is even more worrying is that as time passes, one gets the impression that governments don't seem to have a handle on the situation.

Their credo seems to be 'do something' to which one would like to reply 'think first'. This loss of confidence in governments to get us out of this crisis is a serious problem given that, as economic consultant David M.Smick writes in his new book, "The survival of the world financial system depends on an elaborate confidence game. The size of the financial markets, relative to the governments, has become so monstrously huge that there is no other means of maintaining stability than to establish a psychology of confidence. The governments themselves cannot by edict restore order. They can only project to the markets a sense that they know what they're doing." (1)

The main reproach that one could heap on governments' actions to deal with the crisis is that in order to avoid short-term pain they are willing to risk long-term suffering. It is of course undeniable that the world economy is in a deep recession. This recession however is the consequence of the poor economic policy choices of the last 10 years. There simply is no easy way out of this. Pretending that it is possible to avoid paying the price for past mistakes or to defer paying it to some-time-never is simply not an option even though it may be politically tempting. The solution to the problems created by an excess of private debt should not be to have recourse to an excess of public debt.

This does not mean that governments should do nothing. It now seems clear that the current recession is the worst in the post-war period. It will hurt a lot of people - most of these people are not responsible for this crisis. The great irony of the current situation is that those that were prudent seem to face almost as much pain as those who were reckless. The fact that some of the current policy actions aim to protect the latter from the consequences of their actions also introduces a moral question. The bailout mentality that is currently developing is at risk of eroding the sense of personal responsibility.

Paul Volcker, former Chairman of the Federal Reserve and now a member of President Barack Obama's advisory team on the economy, recently said in a speech, "This is not an ordinary recession. It is much more difficult to get out of and it has shaken the foundations of our financial institutions. The system is broken." Governments' economic policies should therefore not be focused on a quick fix of the economic model that has characterised the last 25 years. That model was based on world growth being pulled by the US economy, the US economy being pulled by the consumer and the US consumer living beyond his means with rising house and asset prices justifying ever-decreasing savings. This model is no longer sustainable. Recent policy actions aimed at perpetuating excess consumption in some countries are not the right kind of response to rebalance the world economy.

Economic policies should rather be aimed at promoting the structural shifts necessary to create a sound basis for future prosperity. This is obviously easier said than done, especially since in the short run, governments must also engage in crisis containment and help the innocent victims of this crisis. Even though everybody agrees for example that an increase in the US savings rate would be desirable in the long run, in the short run too rapid an increase would be catastrophic because of the decrease in consumption and economic growth it would entail. Economists call this the 'paradox of thrift' (what is good for an individual is not necessarily good for the economy as a whole) and in Keynesian economics, it is used as an argument in favor of increased government spending to compensate for the weakness in the private sector.

The current economic discussion has however to a large degree become dogmatic. One is either a Keynesian supporting all kinds of government programmes to get the economy 'back on trend' or one is from the Austrian school advocating a 'do nothing' approach to purge the excesses of the last years. Both views are highly simplistic (and do not honour the work of either school of thought). While higher public spending can be justified, history also tells us that governments have rarely been very successful at solving economic problems. The challenges they face today are numerous:

• The concept of growth itself must be rethought. The voracious appetite for growth, whether on the macro- (GDP growth) or microeconomic (profit growth) level lies at the heart of the current problems. The growth model of the last decades now seems unsustainable, economically as well as ecologically. Yet, most of the policy responses seem aimed at reviving/perpetuating it regardless of the long-term consequences;
  
  
• More specifically, most governments seem to operate under the impression that the cure to the economic problems is more bank lending regardless of credit quality and more consumption regardless of debt levels. They thus delay the deleveraging of both the financial and consumer sectors which is necessary to mend the economy;
  
  
• In a globalised world, economic policies must by definition be coordinated. Tempting as it may be for those unskilled in economics or willing to engage in populist rhetoric, abandoning free trade and imposing protectionism can never be the solution to an economic crisis. As the old adage says, "If goods do not cross borders, armies will". Free trade is even more important today when one of the main challenges for the world economy will be to see Asia replace the United States as the consumer of last resort;
  
  
• Government spending comes at a cost. The borrowing now being done by governments to finance the bailouts, the financial system and the economic stimulus programs (and to compensate for the loss in tax revenues) will create a lasting burden for future generations;
  
  
• Large public deficits will prove much less of a long-term problem if funds are invested in infrastructure projects that create long-term value than if they are wasted on stimulating consumption. In Germany, the old-for-new car subsidies may have led to a temporary rise in care purchases but the programme will have little or no lasting impact on economic growth. Spending tax payers' money to try and fix something which is unfixable does not qualify as sound economic policy;
  
  
• Government resources are not endless. If governments go too far in trying to bail out companies and the economy, they could face insolvency themselves. This is a real worry today in light of the huge sums of money that governments have already devoted to preventing the breakdown of the financial system. The problem is especially serious in Europe where most economists agree that at no other time since the Great Depression was the risk of national bankruptcies as high as it is right now. What makes the situation in Europe so dangerous is the size of the banking system compared to GDP and the fact that banks are suffering not only from the problems that also plague their US counterparts but also from their massive exposure to Eastern Europe;
  
  
• Given the former points, it is especially important to clearly state what economic goals are being sought and what incentives are being created in pursuit of these goals. Economics is all about incentives. The best incentive structure the government has at its disposal is the tax system;
  
  
• In his 1942 book entitled 'Capitalism, Socialism and Democracy', Austrian economist Joseph Schumpeter wrote that the "process of creative destruction is the essential fact about capitalism". Creative destruction is a powerful economic concept, the idea being basically that spurts of innovation will destroy some established companies and give birth to new ones. Examples illustrating that concept range from companies like Polaroid to products such as the cassette tape or the mainframe computer. Creative destruction obviously hurts the workers in the obsolete companies/industries and the normal tendency is to resist it. History shows however that artificially supporting uncompetitive companies with public money is ultimately doomed and that it would be better to use that money to support the workers of these companies. The concept of creative destruction comes to mind today when looking at the US automobile industry or, more generally, when realising that over-production is one of the main problems for the world economy today. Impeding the necessary disappearance or contraction of some businesses prevents the reallocation of resources and innovation process that pave the way for future prosperity;
  
  
• Governments must first and foremost get their priorities right. Spending money to stimulate the economy will achieve little if the banking system remains sick.

The reality today is that no one has any idea how long this crisis will last or exactly how to reverse it. Until trust is somewhat restored, it is difficult to see equity markets find a sustainable bottom. Stock markets have already fallen materially from their highs and some quality companies are trading at attractive valuations. A bear market rally is possible at any time. However, unless some signs of stability start to show, a valuation undershoot is looking increasingly likely.

(1) David M. Smick, The World is Curved (Penguin Group)