By Wolfgang Münchau
Published: March 29 2009 22:37 | Financial Times
So you think you can see the green shoots of recovery? You draw comfort from the recent stabilisation of forward-looking indicators such as new home sales in the US? Or you think the stock market rally marks the end of the crisis? Of course, economic growth rates are bound to improve soon for technical reasons. Otherwise, not much would be left of the global economy by the end of the year.
Even if a recovery were to start early in 2010, as some optimistic forecasters believe, most of the pain of the recession is still ahead of us: unemployment and default rates will rise sharply everywhere. Most of the pain in the financial sector is also still ahead of us. This will feel like a depression long after it has ceased to be one.
I am more worried now than I was a month ago. The main problem is that the feedback loops between the real economy and the banking sector are truly scary. Remember that all the public and private sector forecasters are still busy adjusting their 2009 economic projections downwards. The latest downward revision for Germany came from Commerzbank last week, which now projects 2009 growth at a negative 6-7 per cent for this year.
At this rate of contraction, the number of private and corporate defaults is likely to increase massively beyond some of the stress-test assumptions made by the banks themselves. After the crisis caused by toxic securitised assets, the financial industry is now hit by another crisis of potentially similar magnitude. This looks to be one of the worst credit cycles in living memory.
Economists and policymakers who wonder how much it will take to recapitalise the banking sector are discovering that rescuing the banks is a much more dynamic exercise than they thought. Whatever you think it costs – and there have been widely different estimates – it is likely to end up costing you a lot more for that precise reason. The economy is trapped in a vicious circle where credit crunch and recession mutually reinforce each other.
By the end of December, global banks had written off about $1,000bn (€752bn, £699bn) in bad assets, approximately half of that in the US. Since the onset of the crisis, the writedown of assets in the US has exceeded the provision of new capital. Even the Geithner public-private partnership plan is not going to reverse the expected deterioration of capital ratios at sufficient speed and on sufficient scale. In Europe, new capital exceeded writedowns by a small amount, but on the recent projections I have seen, this trend could reverse sharply this year, unless governments introduce new recapitalisation plans.
In the absence of such plans, the banking sector will continue to contract its balance sheet by cutting lending. This is a totally rational response by the banks. To unfreeze the global financial market therefore requires significant increases in bank capitalisation, not just to the status quo ante, and not just to account for the toxic securitised assets themselves, but to adjust for the stuff that is getting toxic right now and tomorrow. The estimate by Alan Greenspan, the former chairman of the Federal Reserve, that one needs to push the ratio of banks’ equity capital to assets from 10 per cent to 13 or 14 per cent seems plausible to me. After a long period of undercapitalisation, you need a period of overcapitalisation just to get back to normal.
In other words, you have to do quite a bit more than you think you need to do, rather than quite a bit less. This is the main reason why the Geithner plan is not an optimal policy response. It is a very smart plan in terms of the way it is constructed. It provides no-brainer incentives for private investors to buy toxic assets. But it will not produce sufficient recapitalisation, let alone sort out the problem to such an extent that banks start lending again. For all its technical ingenuity, this plan is at best insufficient – and more likely an expensive distraction that delays the inevitable policy response of a government-led recapitalisation programme.
Europeans think they have less of a problem because they already put bank rescue packages in place last October. This is one of the many misjudgments of European officials in respect of this crisis. The current rescue packages are not doing the job. They were emergency measures only. But we have moved beyond the immediate emergency, and need a strategic response. Europe, too, will have to start to address the problem, by forcing banks to write down their assets in exchange for new capital. And not all the banks should survive. We must allow the sector to shrink while we recapitalise. This means many painful and unpopular decisions have yet to be taken.
I have no hope that this week’s Group of 20 summit will provide a solution to this problem. In fact, the old Group of Seven would be a much more appropriate group to discuss a co-ordinated approach about crisis resolution, as most of the world’s most important financial centres are located in these countries.
But it matters less who does it than what is being done. The Europeans need a new plan. And the US needs a better plan.