Banking confidence must be restored

Friday, 20 February 2009 Opinion Pieces

Last week the US Treasury Secretary, Timothy Geithner, introduced the Financial Stability Plan aimed at addressing the credit crisis in the US by cleaning up banks balance sheets and recapitalising some of them. The Plan also anticipates both public and private purchase of bad mortgage-backed securities. According to the latest estimates by the IMF, the total potential losses from loans and other credit securities originating from the US is $2.2 trillion, up from $1.4 trillion in October 2008. At the same time, the US Treasury only has $350 billion left from the $700 billion bank bailout package approved by the Senate last year. The IMF’s study of 122 past banking crises around the world indicates that unless banks balance sheets are cleaned up economic recovery is very slow and painful.

It was only under the “Takenaka Plan” in 2002 when the Japanese government tightened its asset audits that led to the discovery of accurate figures for banks bad assets. This in turn led to sweeping and radical reforms of the banking system in Japan, after prolonged economic stagnation. Given a more pessimistic view of Professor Nouriel Rubini’s estimate that the total losses on loans made by US financial firms including the fall in market value of their assets being $3.6 trillion (where the US banks and brokers are exposed to half of it), the only way that one could verify this figure and then consider policy options including the nationalisation of insolvent banks is if the US authorities follow what Japan did in 2002.

At the present time, political and economic pressure is not allowing the Obama Administration to ask for more funding, given the size of the recent US stimulus package and the sheer size of the US budget deficit which is far too high. Two years ago, the US budget deficit of $400 billion was considered too high however the new budget deficit may well exceed $1.6 trillion in 2009.

Moreover, requesting private and public partnerships to invest in the US banking sector, as proposed by Timothy Geithner, will be ineffective, as Japan experienced during its banking crisis, unless confidence is restored to the banking system first. Until then, the US and some of the European governments may have to act without the support of the private sector thereby adding to their budget deficits.

The IMF produced an analysis of OECD countries from 1960 to 2007 which indicates that private investors generally withdraw from the market well before an official recession hits a country or region. Investors do not return to the market until well after the recession is over. That is why the IMF’s policy has been effective government spending during recessions. However, when a recession is associated with a credit crunch, it will be deeper and its duration longer.

Due to the nature of the current global financial crisis, restoration of confidence in the banking system is a prerequisite for sustained economic recovery. Secondly, unless national stimulus packages are mutually reinforcing and promote free trade, their contributions could be limited, particularly if they are not internationally coordinated. Thirdly, if government’s national banks rescue packages are tied to implicit expectations that banks loans should only be spent on domestic products, and domestic banks are discouraged from lending to overseas markets, then a deeper global recession will occur. While trade protectionism contributed to the emergence of the Great Depression, the current financial protectionism could deepen this global financial crisis.

Despite remarks by Franklin Roosevelt’s Relief Administrator, Harry Hopkins, who used to say, “People don’t eat in the long run. They eat every day,” and despite the emergence of a number of new national institutions during the Great Depression, employment in the US was lower in1939 than in 1929. It was only during the Second World War that the US economy was restored to full capacity. A nationalistic approach and an inadequate international financial system during that global crisis made the process of recovery much more difficult.

Unlike the 1930s, the global economy is much larger and far more interdependent with large nations such as Brazil, China and India adding millions of new middle income consumers to it. Unlike the Great Depression period, the new century is associated with financial globalisation that contains a massive amount of private financial wealth ready to be deployed if the global financial environment is restored to normal. At the same time, the governments of China, Japan and Russia are amongst the largest foreign reserves holders, while the US government is the largest debtor country.

At this point, the private sector has virtually withdrawn from the market, as the current global financial crisis led to a global leadership crisis. Emerging countries are faced with a shortage of foreign private capital which in turn is adding to an increase in the number of unemployed in 2009 as compared to 2007, which according to the ILO, is between 35 and 50 million.

All this indicates that although the lessons of the 1930s were that national governments should spend and invest in the economy during an economic downturn and Japan’s half-hearted intervention policy for her banking system in the 1990s led them to advise the American authorities that they should spend more in their banking system, and do it quickly, we do not know the extent of the US banks toxic assets and the amount of resources needed to address it. However, unless confidence is restored to the US banking system and banks start lending again, the new US stimulus package may not have a significant effect on the real economy. The international financial market is now focused on the outcomes of the G20 Summit to be held in London in early April.

Fariborz Moshirian is an editor of the Journal of Banking and Finance and Professor of Finance at the Australian School of Business.

This is an edited version of an opinion piece published in the Australian Financial Review on 18 February 2009.