Against the tide: From bail-out to recession
Governments worldwide have moved to recapitalize banks. But the amounts injected will only be sufficient to avert a great depression; they are not enough to sustain lending and avert a global recession.
The banking bail-out packages announced by the UK, the US and the European Union are a symphony of unified policy measures, adopting the classic approach to the credit crisis. The UK plan was close to the Swedish model of 1991 – a tried and proven restructuring recipe for salvaging the banking sector.
The EU plan also gives a pledge to guarantee inter-bank lending until the end of 2009; permission for governments to shore up banks by buying preferred shares; a commitment to recapitalize any systemically critical banks in distress; and a reiteration of previous promises that depositors’ money is safe.
Other countries have also stepped up. Australia is to guarantee all deposits for the next three years and all wholesale funding in international credit markets. New Zealand said it would guarantee retail deposits, and Norway will offer commercial lenders as much as $55 billion in government bonds in exchange for mortgage debt. And the US has been scrambling to adapt its original poorly conceived programme to the sensible UK blueprint by switching the focus of its resources towards the recapitalization of banks.
But there is a missing bit in all these plans: they have fixed the recapitalization and counterparty risk issues but not the write-off issue. You can’t calculate how much capital a bank needs unless you know how much it has lost. That can’t happen without a strict system of write-offs. If the loans and attached assets are not written off, they will sit like a cancer in the banks and paralyze the allocation of capital.
This is what the Japanese allowed in their crisis in the 1990s. The authorities injected oodles of state capital into banks and bought their non-performing loans but they didn’t force the banks to write off their dud assets. As a result, the economic landscape of Japan was littered with zombie banks and corporations that were then responsible for the lost decade (and a half).
Last November, we made an estimate of the likely losses to be suffered by financial institutions globally from the credit crisis at $1.4 trillion, or about 3% of global GDP. The latest IMF estimate of losses approximates to this figure too.
Expected total losses from the credit crunch
Now the taxpayer is going to have to take a share of these losses. The 1988–92 US savings and loans crisis incurred a final fiscal cost of just 3.7% of GDP, and Sweden’s 1991 bank crisis cost the taxpayer only 3.6% of GDP. Building in an allowance for losses that governments might incur by buying non-performing loans or bailing out mortgages might double or even triple these figures. But even a net fiscal cost of 10% of GDP is manageable – although it’s very bad news for government bond markets. So the job can be done. But salvaging the banking system is one problem; even bigger is the damage that the credit crisis is inflicting on the wider economy. Every dollar of these losses destroys bank capital, which, in turn, supports $10 to $12 of lending on average, which cannot take place without it. Any deleveraging (the contraction of loans that capital destruction causes) will affect the real economy. And without global credit growing by at least 7% a year, OECD GDP cannot grow at its normal rate of 2% to 3% a year.
We estimate that the amount of new bank capital required (given the losses incurred) to achieve that is around $1.1 trillion. Before the injections of capital by governments, about $420 billion of new capital has been raised, so the system still needs about another $630 billion to restore normal lending growth. So far, various governments plan to inject up to $220 billion, still some way short of what is necessary to ameliorate the recession.
All the banking packages will do is avoid a great depression that would have occurred if the systemic failure of global finance had continued. What they will not do is avoid a global recession. Global credit will contract even if the banks stabilize their balance sheets.
In the past two decades, the world has more than doubled the amount of credit it uses to produce a unit of GDP. It will have to learn to use less. This will be a lengthy and painful adaptation. Profligate borrowers have to move from living on leverage to living by thrift. First to suffer will be the US consumer – the engine of global excesses. This will be a multi-year process affecting many countries’ growth, especially the factory economies of Asia and the commodity exporters of Latin America. The immediate impact will be to spread recession from the US and Europe to the poorer supplier nations.