Fix US banks first to end global recession

Laissez-faire capitalism is history.

Advanced economies are already in a "depression" and the financial crisis may deepen unless the banking system is fixed, IMF chief Dominique Strauss-Kahn said in Kuala Lumpur in early February.

The world is gripped by "a great recession," he said recently.

"Our belief and expectation is that we will get all the pillars in place for recovery this year," said President Barack Obama recently.

Yet, such optimism may be unfounded. According to World Bank president Robert Zoellick, growth in the world economy is likely to fall by up to 2 percent this year. The key to long-term stability is sorting out banks.

"Stimulus plans will be like a sugar high unless you fix the banking system," he says.

Fixing the banks is the first step in overcoming the great global recession - first in the US, then elsewhere.

When President Obama was promoting his stimulus plan on Capitol Hill in February, the White House prepared to promote a "massive" bank rescue plan.

Despite grand expectations, the initiative never materialized.

As great expectations tanked, the market plunged.

The problem is the basic premise. Treasury Secretary Timothy Geithner's plan presumes that the banking system is basically intact and can be repaired incrementally.

In fact, the "zombie-banks" - the large banks that survive largely through Washington's funding - would be in receivership without public support. In other words, the sector is "technically insolvent".

In order to avoid the fate of Japan in the 1990s, one way to resolve the crisis is through the temporary nationalization of the banking system. Still, the administration has not been willing to explore this option, even though it has been supported by a wide array of highly regarded observers.

Last September, the fall of the investment bank Lehman Brothers triggered the dramatic plunge of the markets. Today, even Citigroup and Bank of America are struggling to cope with the crisis.

Now the stakes are much higher and time is far more precious. In normal times, the pace of the Obama administration would have been overwhelming, but these are not normal times.

The deeper and more protracted the great global recession will be, the more it will cause firms and households to default on their loans and mortgages.

Last fall, the Troubled Asset Relief Plan (TARP) by the then-Secretary of Treasury Hank Paulson comprised some $700 billion to rescue US banks. Geithner's plan includes an estimated $250 billion from the Obama stimulus plan.

Yet, total losses on loans made by US banks and the fall in the market value of the assets they are holding could reach $3.6 trillion, while the US banking sector is exposed to half that figure, or $1.8 trillion.

In a recent interview, President Obama also noted that the banking crisis could lead to yet another $750 billion stimulus plan.

But it's all too little too late. More is needed - the sooner, the better.

Still, most of the top posts beneath Geithner remain vacant. The Administration has also postponed the plan to complete a road map for overhauling the nation's financial regulatory system by April.

Delays contribute to accumulating problems. After all, it is the Treasury that should play the key role in the rescue of the US financial system, car industry and housing markets.

The markets have not bottomed out yet. More losses lay ahead. As long as the fate of the US banking sector remains in doubt, the bears expect another 10-15 percent plunge and, in certain conditions, a 25 percent dive - down to Dow 5,000.

In the long term, other problems are bound to arise.

The Obama budget projects that, during the ongoing year, the deficit will grow to 12.3 percent of GDP, which means an increase of debt as a percentage of GDP to almost 60 percent.

According to the budget, unemployment will amount to 8.1 percent in 2008. Yet, this figure was exceeded already last month. It is now quite likely that unemployment will be more than 10 percent before the end of the year.

That may be too little too late. Due to the rapid deterioration of the economy, businesses are not just cutting back, which is normal in a recession; many are divesting activities, while industries are partly dismantled.

After the dust settles, the landscape of the world economy may look very different.

"We are suffering just now from a bad attack of economic pessimism. It is common to hear people say that the epoch of enormous economic progress which characterized last century is over; that the rapid improvement in the standard of life is now going to slow down; that a decline in prosperity is more likely than an improvement in the decade which lies ahead of us."

This is an apt description of the current mood. The author is the famed economist John Maynard Keynes, and the words originate from 1930. The great global recession is not the Great Depression - but the footprints should caution us all.

In early April, the G20 summit in London will try to coordinate a worldwide effort to tackle the global financial crisis. A consensus on the next summit date is no longer enough. What is needed now is decisive, rapid and internationally coordinated cooperation.

Recently, China's Premier Wen Jiabao has expressed valid concerns about the US government debt China holds, urging Washington to take effective policies to restore the US economy to health.

The first step is to fix USbanks in order to unleash credit, business investment and consumer spending.

The author is the Research Director of International Business at the India, China and America Institute.

(China Daily 03/20/2009 page9)