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Springtime of zombie banks, 'green sprouts' leads to dark winter

By Joseph E. Stiglitz | May 11, 2009, Monday | Print Edition

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 administrations have changed, but not the optimism.

The 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 the global economy is set for a robust recovery any time soon. Hitting bottom is no reason to abandon the strong measures taken to revive the global economy.

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 forever.

A recovery

The collapse of credit made matters worse; and firms, facing high borrowing costs and declining markets, responded quickly, cutting back inventories. Orders dropped abruptly and countries that depended on investment goods and durables were particularly hard hit.

We are likely to see a recovery in some areas.

But examine the US fundamentals: real estate prices continue to fall, millions of homes are under water, 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 capitalized - a "stress test" - and some couldn't pass muster.

But, rather than welcoming the chance to recapitalize, the banks seem to prefer a Japanese-style response: muddling through.

"Zombie banks" - dead but still walking among the living - are "gambling on resurrection." The banks are using bad accounting. Worse still, they are allowed to borrow cheaply from the Fed using poor collateral, and simultaneously to take risky positions.

Some of the banks did report first-quarter earnings, 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 US taxpayers will be even larger.

The US government, too, is betting on muddling through: the Fed's measures and government guarantees mean 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 survive without another crisis. In a few years the economy will return to normal. This is the rosy scenario.

Experience suggests this is a risky outlook. Even were banks healthy, the deleveraging process and associated loss of wealth means that the economy will likely be weak and banks will lose more.

The problems are worldwide. In a globalized world, problems in one part of the system quickly reverberate elsewhere.

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.

Every 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.

(Joseph E. Stiglitz, professor of economics at Columbia University, chairs a Commission of Experts on reforms of the international monetary and financial system. Copyright: Project Syndicate, 2009. www.project-syndicate.org)

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