In response to the worldwide financial crisis, G-7 policymakers have taken dramatic, albeit belated, steps to avert a complete meltdown. It is unclear, however, whether these measures will be sufficient to a) stave off the worst global recession since World War II, b) forestall further nationalization of the banking system, and c) prevent the overregulation of international finance.

The present crisis is the result of a vicious spiral of asset price deflation and financial deleveraging, which was triggered by the collapse of America’s housing bubble in late 2006. The crisis has now spread well beyond the mortgage market. Since the beginning of 2008, global equity prices have declined by around 35 percent, while the overall decline in U.S. asset prices—including homes, equities, and bonds—has reduced U.S. household wealth by more than 80 percent of GDP.

It is too late to prevent a severe global recession.

Falling asset prices have forced banks to recognize large loan losses, which has eroded the capital on which their lending operations are based. This has induced the banks to sell assets and curb lending in an effort to mend their highly impaired balance sheets. That, in turn, has inflicted major damage on the real sector of the global economy and ignited fears of a worldwide recession.

To date, banks at the global level have recognized more than $550 billion in loan losses but have raised only $400 billion or so in new capital. Over the coming months, bank loan losses will rise considerably as the global recession deepens. The International Monetary Fund estimates that the eventual loan losses to the global financial system will total roughly $1.4 trillion.

To their shame, G-7 policymakers were exceedingly slow to grasp the nature and severity of the present recession. Worse still, it took a crash in global equity markets and the freezing up of credit before policymakers recognized that the banking crisis had more to do with solvency than liquidity.

A large portion of the banking sector will be partially or wholly nationalized, and the remaining portion will be largely concentrated in the hands of a few mega-banks.

During the past week, individual G-7 countries have at last announced bold measures to infuse much-needed capital into their banks, to expand depositor protection, and to guarantee interbank lending. In time, these measures will allow the banking system to return to normalcy. But in the short run, it is too late to prevent a severe global recession. To ensure that the recession does not morph into something nastier and more protracted, G-7 policymakers should coordinate their fiscal and monetary policies to support global aggregate demand. More specifically, they should combine fiscal stimulus with monetary easing.

While banks have been reducing the size of their balance sheets, many non-bank financial institutions—including hedge funds, private equity funds, and structured investment vehicles—have also been forced to deleverage their portfolios. This deleveraging by non-banks—which, at least in the United States, are more important than banks in overall financial market intermediation—will continue apace despite the bold measures being taken to shore up the banking sector.

When the dust settles on today’s crisis, the world will find itself with a radically changed financial system. A large portion of the banking sector will be partially or wholly nationalized, and the remaining portion will be largely concentrated in the hands of a few mega-banks. Most investment banks will have exited the scene, along with probably half of all hedge funds and private equity firms.

There is almost certain to be a strong political backlash against the global financial system, which could produce excessive new regulations that stifle financial competition and innovation. This would be most unfortunate. As the Sarbanes-Oxley Act demonstrates, overregulation can be just as harmful as underregulation. We may have to learn that lesson all over again.

Desmond Lachman is a resident fellow at the American Enterprise Institute. A version of this article originally appeared in the German newspaper Handelsblatt.

Image by Darren Wamboldt/The Bergman Group.