We started 2011 in recovery mode, admittedly weak and unbalanced, but nevertheless there was hope. The issues appeared more tractable: how to deal with excessive housing debt in the US, how to deal with adjustment in countries at the periphery of the euro zone, how to handle volatile capital inflows to emerging economies, and how to improve financial sector regulation.

It was a long agenda, but one that appeared within reach.

Old drachma coins, Greece’s former currency, sit on sale at a market stall in Athens, Greece (Bloomberg)

First, after the 2008–09 crisis, the world economy is pregnant with multiple equilibria—self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications. Multiple equilibria are not new. We have known for a long time about self-fulfilling bank runs; this is why deposit insurance was created. Self-fulfilling attacks against pegged exchange rates are the stuff of textbooks. And we learnt early in the crisis that wholesale funding could have the same effects, and that runs could affect banks and others alike. This is what led central banks to provide liquidity to a much larger set of financial institutions.

What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. Like banks, government liabilities are much more liquid than their assets—largely future tax receipts. If investors believe they are solvent, they can borrow at a riskless rate; if investors start having doubts, and require a higher rate, the high rate may well lead to default. The higher the level of debt, the smaller the distance between solvency and default, and the smaller the distance between the interest rate associated with solvency and the interest rate associated with default.

Second, incomplete or partial policy measures can make things worse.

We saw how perceptions often got worse after high-level meetings promised a solution, but delivered little. Or when plans announced with fanfare turned out to be insufficient or hit practical obstacles. The reason, I believe, is that these meetings and plans revealed the limits of policy, typically because of disagreements across countries. Before the fact, investors could not be certain, but put some probability on the ability of players to deliver. The high-profile attempts made it clear that delivery simply could not be fully achieved, at least not then.

Third, financial investors are schizophrenic about fiscal consolidation and growth.

They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds. To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.

Fourth, perception moulds reality.

Right or wrong, conceptual frames change with events. And once they have changed, there is no going back. For example, nothing much happened in Italy over the summer. But once Italy was perceived as at risk, this perception did not go away. And perceptions matter.

Put these four factors together, and you can explain why the year ends much worse than it started.

Is all hope lost? No, but putting the recovery back on track will be harder than it was a year ago. It will take credible but realistic fiscal consolidation plans.

Olivier Blanchard is chief economist of the International Monetary Fund, on leave from the Massachusetts Institute of Technology

Edited excerpts. Published with permission from VoXEU.org. Comment at otherviews@livemint.com