Global stock markets have been gyrating wildly in tandem with the latest news on the US treasury’s $700 billion package to bail out the banking system in that country. Investors have been rushing in to buy stocks whenever there are moves towards a closure of the bailout deal and have rushed to the exits whenever it threatens to get stalled in the US legislature. The underlying assumption is that the Paulson plan will pull the markets out of the hole they have fallen into.

Illustration: Malay Karmakar / Mint

It is really not that simple. A bailout deal of that proportion — which could grow in size as the months go by — will very likely push the US deeper into debt and a fiscal mess.

A new working paper released by the International Monetary Fund (IMF) last week drives home some plain truths. The IMF economists who have written this paper have examined 124 banking crises over the past 27 years. They say the average fiscal cost of managing a banking crisis is 13.3% of gross domestic product (GDP). Compare this with the $700 billion — or 5% of current US GDP — the Bush administration plans to spend. Going by the average numbers, it could end up spending a $1trillion more. Or even more: remember that many economists now believe that this is the worst financial crisis in the US since the Great Depression.

Any country that goes through a systemic financial crisis has to pay the price with either a recession or a sharp deterioration in government finances, if not both. The first will harm corporate profits. The second will push up interest rates. Neither is good news for the equity markets.

Domestic investors, too, have been eager participants in these bursts of optimism — first buying into the ridiculous idea that a country such as India, with global trade links that equal 50% of its GDP, can decouple from the rest of the world; and now hoping that one $700 billion shot will cure a chronic malady.

Anirvan Banerji, director of research at Economic Cycle Research Institute and a respected forecaster, has told DNA in an interview that “according to our leading index, India is headed into its worst slowdown in at least a decade". This is in stark contrast to the glib forecasts that government economists, corporate executives and stock brokers have been making. India is very unlikely to see its economy shrink, which is what a recession really is. But investors have to be prepared for a slowing economy, unimpressive profit growth and perhaps higher interest rates as well.

Let’s not pretend that Paulson has a magic wand.

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