Jeremy Warner: Policy therapy may be inappropriate as well as ineffective

Outlook First governments flooded the beleaguered banking system with money. Now interest rates are being slashed and nations are again turning on the spending taps. Rarely if ever has an economic downturn been met with a public policy response of such awesome size and international magnitude. Enough, surely, to reverse the tide of economic woe? If only it were that simple. Policy-makers have to do something, and it may well be that there is nothing else they can do other than chuck money and reductions in interest rates at the problem. Yet major concerns over both the effectiveness and appropriateness of the response remain. One is that whatever the authorities do, they may be powerless in the face of the worldwide shrinkage in credit now under way.

Once banks start to reduce the size of their assets, or lending, the process becomes very difficult to stop until the perceived debt overhang is removed. Cuts in interest rates are all very well, but do the authorities really want to encourage the already overborrowed to borrow even more? Most householders and businesses are already struggling to pay off what they already owe. It's a strange kind of solution to the crisis which advocates dealing with its consequences by applying even more of what caused it.

That's what happened in the early "noughties" too, when worries about deflation post the collapse of the dotcom bubble caused the Fed to slash interest rates all the way down to 1 per cent. Everyone now agrees that interest rates were cut too low for too long, prompting the debt-fuelled consumption which led directly to the present crisis. Policy cannot for ever keep putting off a necessary period of adjustment. There's a very thin line indeed between policy aimed at preventing a crisis running out of control and policy that merely stokes the flames for an even worse crisis to come.

Nor is the political pressure now being applied to banks to maintain or even increase their lending to households and businesses an obviously healthy development. This again only increases moral hazard if it supports the fundamentally uncreditworthy. It also amounts to a form of protectionism, since international banks forced by home governments to focus shrinking credit on undeserving domestic lending will be unable to pursue possibly more attractive lending opportunities in the developing world and elsewhere.

The politicians generally mean well, but the moment they start meddling in credit allocation, there's likely to be a whole host of unintended consequences.

In America, the Federal Deposit Insurance Corporation is planning to issue up to $500bn in mortgage guarantees to help stave off the growing tide of foreclosures. Nobody wants to see people chucked out of their homes, but is it right that those who have borrowed beyond their means should be forgiven their debts? If that's what householders can expect, they will be even more reckless next time.

But perhaps even worse than well-intentioned meddling is no political leadership at all, which is what they've got in the US until the new president is sworn in next January. According to figures released yesterday, the US economy has turned negative for the first time in seven years. An economy already teetering on the brink and a power vacuum at the top is a recipe for disaster.

Lower official interest rates may be good for sentiment, but they only apply to very short-term borrowing and this is not where the problem is. What's undermining business is the availability and cost of longer-term funding. For this to revive requires healthy banks. Few of them are yet off the critical list, let alone into the recovery ward. Credit shrinkage is likely to be a drag on business activity and asset prices for some time to come yet.