Through the unfolding of the financial crisis, I have been an optimist, looking at the situation in technical terms, and seeing light at the end of the tunnel. Since late last summer, that seems to have been the attitude of US policymakers, as they have taken one measured step after another to defuse the crisis. But it seems that the rot keeps spreading ahead of the fixes. European governments and multilateral institutions are now dealing with their pieces of the financial fallout. Real economic activity is starting to plummet.

The immediate problem is the lack of short-term liquidity. Credit markets that are normally the lifeblood of every modern economy are frozen with uncertainty. The uncertainty is coming from not knowing if the institution that wants to borrow can be trusted to repay. Not even the potential borrowers know the state of their own balance sheets. Perceptions of risk have gone through the roof.

Policymakers have finally been dealing with the problem, by offering to have governments insure such transactions. But meanwhile, the credit crunch has set off the second stage of the crisis. The uncertainty about repayment is coming about because many institutions hold assets that may have been seriously mispriced. The original source of this mispricing was securitized subprime mortgages, but large amounts of derivative securities, ostensibly designed to improve risk sharing, have been piled on top of this rotten foundation. Liquidity problems can force the selling of overvalued assets — as their true value is revealed, the holders of the assets may become technically insolvent. This sets off a chain reaction across the web of interdependent holdings of financial assets. Markets can also overshoot in this situation, so that artificial, temporary insolvency is created. Restoring liquidity can help, but meanwhile the need for liquidity has grown.

Even without insolvency, asset holders across the economy see their wealth reduced as assets prices fall to new, more realistic levels. Wealth reductions cause pullbacks in real spending. As consumption and investment fall, production and real economic activity follow them down. As reality becomes bleaker, of course, realistic asset price levels decline. Animal spirits give way to panic.

Recessions are not new, nor are financial crises. We have had our share in recent decades. What seems to be different right now is the scale of the problem. Governments are spending to buy bad assets, and taking on new contingent liabilities, such as insuring short-term borrowing and increasing deposit insurance. Their fiscal positions will become more fragile. Real economic growth can help reduce this fragility by generating tax revenue to pay for the borrowing, but growth will be lower in the short run. Another way to pay is to tax everyone through inflation, which can also hurt growth. Again, the challenge is the size of the problem — some governments may run out of room to operate if they cannot borrow enough in the short run to make good on their increased insurance commitments and finance their asset purchases.

Global coordination may be essential to manage the financial crisis, but so far has been mostly lacking. Without coordination, if one moves on from financial institutions going under to countries going to the wall, or being forced to borrow from multilaterals with stringent conditionalities (taxing their constituents to pay back their loans), the political consequences may be ugly. The financial crisis comes on the heels of (and maybe was a result of) an unprecedented economic boom but unfortunately, not political stability. Political fragility may ultimately be a greater threat than the financial crisis itself.

The world can step back from this abyss if there is globally coordinated action and a sense of leadership. The US is in the process of replacing a lame-duck, miserably unpopular president who seems to be at a total loss. New leadership may help there. Other global leaders will also have to step up. The US and Europe still account for a large fraction of global GDP, but Asia’s economies, with their high savings, large reserves and robust growth, will have to play a role. Exchange rate policies may need to move away from keeping currencies low to boost exports. Boosting domestic demand may once again be a good idea, especially as key commodity prices have deflated remarkably, and that source of inflation has receded as a threat.

India is still a tiny fraction of the world economy, but an even more aggressive cutting of the cash reserve ratio, and quickly starting to bring down interest rates seem to be called for, even just for domestic reasons. The global deleveraging is going to happen, it is going to be severe, and it is going to lead to a significant slowdown in real growth. Indian monetary authorities should act boldly in staying ahead of this process. Acting decisively with the right accompanying words would signal that policymakers are in charge in this difficult time. All major governments need to do the same.

Nirvikar Singh is a professor of economics at the University of California, Santa Cruz. Your comments are welcome at