Wolfgang Munchau often has a dour outlook, but his Financial Times comment today, “A new plan needed as the cycle grows vicious” is gloomy even by his standards.
Munchau argues that the heroic seeming measures to aid the banks are insufficient to compensate for the losses they are and will continue to suffer, and that as they understandably rein in lending, it will make the contraction more severe, worsening credit losses and deepening the cycle. Meredith Whitney has been making similar comments, but with a tad less urgency than Munchau.
While I agree with his concern, that a contraction can slip into a vicious circle, focusing on recapitalization as the primary policy response is wrongheaded. The Swedish in their salvage operation not only took over dud banks and hived off the bad assets, but they restuctured those loans and sin some cases even extended more credit to borrowers. And bailouts to banks without banking reform is a bad idea (and I see the Geithner talk of new measures as window dressing to appease the public in the hopes of eliciting support for the inevitable next round of rescues).
The only way out of a financial crisis is default, whether overt, through writeoffs and resturcturings, or covert, through inflation. This process isn’t even seriously underway until we see a lot more renegotiation.
From the 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….
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…
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….
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….
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. …. 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 Octo….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….
The Europeans need a new plan. And the US needs a better plan.