Green Shoots? Don't Speak Too Soon

In spite of some spring sprouts in the US economy, we should prepare for another dark winter

As spring comes to America, optimists are seeing "green sprouts" of
recovery from the financial crisis and recession. The world is far
different from what it was last spring, when the Bush administration
was once again claiming to see "light at the end of the tunnel". The
metaphors and the administrations have changed, but not, it seems, the optimism.

good news is that we may be at the end of a free fall. The rate of
economic decline has slowed. The bottom may be near - perhaps by the
end of the year. But that does not mean that the global economy is set
for a robust recovery any time soon. Hitting bottom is no reason to
abandon the strong measures that have been taken to revive the global

This downturn is complex: an economic crisis combined
with a financial crisis. Before its onset, America's debt-ridden
consumers were the engine of global growth. That model has broken down,
and will not be replaced soon. For, even if America's banks were
healthy, household wealth has been devastated, and Americans were
borrowing and consuming on the assumption that house prices would rise

The collapse of credit made matters worse; and firms,
facing high borrowing costs and declining markets, responded quickly,
cutting back inventories. Orders dropped abruptly - well out of
proportion to the decline in GDP - and those countries that depended on
investment goods and durables (expenditures that could be postponed)
were particularly hard hit.

We are likely to see a recovery in
some of these areas from the bottoms reached at the end of 2008 and the
beginning of this year. But examine the fundamentals: in America, real
estate prices continue to fall, millions of homes are underwater, with
the value of mortgages exceeding the market price, and unemployment is increasing,
with hundreds of thousands reaching the end of their 39 weeks of
unemployment insurance. States are being forced to lay off workers as
tax revenues plummet.

The banking system has just been tested to
see if it is adequately capitalised - a "stress" test that involved no
stress - and some couldn't pass muster. But, rather than welcoming the
opportunity to recapitalise, perhaps with government help, the banks
seem to prefer a Japanese-style response: we will muddle through.

banks - dead but still walking among the living - are, in Ed Kane's
immortal words, "gambling on resurrection". Repeating the savings and loan debacle
of the 1980s, the banks are using bad accounting (they were allowed,
for example, to keep impaired assets on their books without writing
them down, on the fiction that they might be held to maturity and
somehow turn healthy). Worse still, they are being allowed to borrow
cheaply from the United States Federal Reserve, on the basis of poor
collateral, and simultaneously to take risky positions.

Some of
the banks did report earnings in the first quarter of this year, mostly
based on accounting legerdemain and trading profits (read:
speculation). But this won't get the economy going again quickly. And,
if the bets don't pay off, the cost to the American taxpayer will be
even larger.

The American government, too, is betting on muddling
through: the Fed's measures and government guarantees mean that banks
have access to low-cost funds, and lending rates are high. If nothing
nasty happens - losses on mortgages, commercial real estate, business
loans, and credit cards - the banks might just be able to make it
through without another crisis. In a few years time, the banks will be
recapitalised, and the economy will return to normal. This is the rosy

But experiences around the world suggest that this is a
risky outlook. Even were banks healthy, the deleveraging process and
the associated loss of wealth means that, more likely than not, the
economy will be weak. And a weak economy means, more likely than not,
more bank losses.

The problems are not limited to the US. Other
countries (like Spain) have their own real estate crises. Eastern
Europe has its problems, which are likely to impact western Europe's
highly leveraged banks. In a globalised world, problems in one part of
the system quickly reverberate elsewhere.

In earlier crises, as
in east Asia a decade ago, recovery was quick, because the affected
countries could export their way to renewed prosperity. But this is a
synchronous global downturn. America and Europe can't export their way
out of their doldrums.

Fixing the financial system is necessary,
but not sufficient, for recovery. America's strategy for fixing its
financial system is costly and unfair, for it is rewarding the people
who caused the economic mess. But there is an alternative that
essentially means playing by the rules of a normal market economy: a
debt-for-equity swap.

With such a swap, confidence could be
restored to the banking system, and lending could be reignited with
little or no cost to the taxpayer. It's neither particularly
complicated nor novel. Bondholders obviously don't like it - they would
rather get a gift from the government. But there are far better uses of
the public's money, including another round of stimulus.

downturn comes to an end. The question is how long and deep this
downturn will be. In spite of some spring sprouts, we should prepare
for another dark winter: it's time for Plan B in bank restructuring and
another dose of Keynesian medicine.

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