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
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
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.
AGSM Scholar, Professor, Director of the Institute of Global Finance
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