The good news last week was the British and US Governments finally drawing a line under the collapse of their sickest financial institutions, Royal Bank of Scotland and Citibank. The bad news is that this was the fourth such “final” resolution and each of the previous lines in the sand had been rubbed out within a month. The appalling uncertainty about whether banks that are deemed “sound and well-capitalised” by their regulators one week will suddenly be declared by the same regulators to be insolvent largely accounts for the manic depressive mood swings of the financial markets since last autumn. It also explains the almost comical revisions to all the data and projections published in recent weeks by the world's most respected economic institutions.

The problem is that conditions in the world economy today are what mathematicians call “path-dependent”. In a period of normal growth, it doesn't matter whether there are some bumps in the road — for example, changes in government policy or delays in important announcements, such as the agreement to insure Lloyds Banking Group's toxic assets. Like a cyclist with plenty of momentum, the economy just keeps on going. But when it is unstable, even a small change in external conditions can have a hugely amplified effect. Imagine a pencil balanced on its tip, for example; the tiniest wisp of a draft will determine which way it falls.

It is this path-dependence that explains why real-world economists — as opposed to the Delphic oracles who merely repeat the same bullish or bearish pronouncements — have been lurching around so much in recent months. To see what I mean, consider the growth projections published on November 25 by the Organisation for Economic Co-operation and Development (OECD), the world's pre-eminent forecasting institution. The OECD predicted that in the fourth quarter of 2008, GDP would fall by 2.8 per cent annualised in the US, by 2.1 per cent in Britain and by 1.0 per cent in the eurozone, Germany and Japan. Last week we learnt the actual figures: US GDP fell by 6.2 per cent annualised, Britain by 6 per cent, the eurozone by 6 per cent, Germany by 8.2 per cent and Japan by 12.8 per cent.

My point in noting the egregious errors in these forecasts, published when the period in question was already halfway through, is not to suggest that economics is completely useless. It is to highlight what economics can and can't do. Economists cannot predict when the recession will end, but this does not invalidate the basic insights of economics any more than the inability of meteorologists to predict the weather. What economics can tell us is that any recovery will be accelerated and strengthened if governments and central banks pursue certain policies. These include reducing interest rates, expanding the money supply, increasing public spending, cutting taxes and accepting large public deficits.

Even more importantly, economics tells us that recovery will depend on restoring the flow of credit. Every day wasted in stabilising the banks will deepen the recession and result in permanent losses in output, jobs and government revenues. And, because of the path-dependence already mentioned, these losses could be vastly disproportionate to the initial causes. Days wasted in arguments over bank rescues could end up costing many times more in lost tax revenues than the cost of financial numbers in dispute.

Which brings me back to last week's disappointments. Until Friday morning, there were genuine reasons for hope. The asset protection scheme announced for RBS on Thursday really did look like a sensible way of drawing a line under the losses of all the British banks, thereby restoring conditions for normal lending. The British announcement was even more constructive at a global level, adding to the credibility of the “stress testing” and asset purchase programme announced two weeks earlier by Tim Geithner, the US Treasury Secretary, by showing how a similar philosophy could work in practice. Not only were the financial conditions reasonable, but Britain's determination to avoid nationalising RBS should have bolstered confidence worldwide. Nationalising potentially insolvent banks and wiping out shareholders has become the new intellectual fad, promoted by an unholy alliance of right-wing market fundamentalists and left-wing neo-socialists, who are united only by their loathing of postwar mixed-economy capitalism. But this “hard-headed” approach to the rights and responsibilities of financial investors, when applied to Lehman Brothers, was exactly what triggered the present crisis.

The nationalisation of any significant bank would trigger a wave of panic among the shareholders in all other banks and financial institutions. This was the mechanism I described last autumn as the Paulson Doomsday Machine and it brought the world financial system to the brink of collapse within a week of Lehman. Reactivating this doomsday machine by nationalising RBS or Citibank would have meant that all major banks and insurance companies in the world would almost certainly have to be nationalised. That, in turn, would mean that all capital allocation in the entire world economy was brought under state control. Is that really what free-market purists who demand harsher terms to “punish” bank shareholders want to see?

Given the sensible balance between the interests of taxpayers and banks struck last Thursday by the RBS support scheme, it was all the more disappointing that the Treasury failed to announce a similar agreement the next day with Lloyds. And it was downright shocking that the US Treasury chose that same day to announce a punitive financial restructuring of Citibank.

Bank shares worldwide slid in response to the Citibank “recapitalisation” - and by the time markets closed on Friday, investors were again asking whether full-scale nationalisation was inevitable, not only for RBS and Citibank, but also for Lloyds and Bank of America, perhaps for Barclays and Wells Fargo, maybe even for JPMorgan and HSBC.

Officials insisted over the weekend that there was nothing significant about the delay - it was merely a matter of exhaustion among those involved and the sheer volume of bank loans to be examined and priced. The word from Washington, similarly, was that the Citibank refinancing was sui generis and that such punitive treatment would not be meted out to other US banks. If this turns out to be true and a deal with Lloyds is announced within the next few days, then no great harm will have been done - especially if the US Treasury also makes clear that shareholders in other banks can expect better treatment than those at Citi. The risk is that bureaucratic delays will drag on and politicians will wait until the populist feeling against bankers subsides before approving support operations that are truly credible and comprehensive. If that happens, we can expect many more “lines in the sand” to be drawn, and redrawn, before this crisis is over.

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