meeting is in the backdrop of a crisis of confidence in the developed economies driven by three main factors: fledgling growth, fragile balance sheets and indecisive politics.
The problem is not so difficult to understand, although it is not so easy to solve. Countries like Greece, Italy, Spain and Portugal have borrowed in the past decade much more than what they can possibly repay. The lenders to these countries are primarily the large European banks. The banking industry has a problem of its own of being highly leveraged. The banks have far too little equity to save themselves against a downturn in their economic fortunes. So, sovereign risk has spilled over to the regions banking system and this has put funding strains on banks. Because of increased market pressures, banks are being forced to speed up deleveraging, which has curtailed the credit outflow to the larger economy thereby worsening the economic drag.
The choice that the European Union has is two-fold. Let the countries with high sovereign debt default, which might possibly happen in the case of Greece, or convert the European Union into a Western Union Money Transfer. Essentially, the well-to-do countries like Germany and France can do a fund transfer and bail out countries with high sovereign debt and therefore rescue the banks from further asset impairment. The politicians arent too keen on this as it would be an unpopular measure. Hypothetically, if India, Bangladesh, Nepal and Sri Lanka had an economic union and Sri Lanka had huge outstanding debt, which it had borrowed from private banks in India, the Indian taxpayer would not be too happy if the government were to transfer our tax payments to Sri Lanka in order to rescue the private banks. A similar predicament awaits the richer countries in the European Union.
Across the Atlantic, the US government has a slightly different problem. The US federal government has a huge debt burden, which has been financed by the rest of the world, most notably China. Concurrently, US households are repairing their balance sheets by paying down debts and building up savings. During the last three years, the value of real estate assets and financial assets have plunged, thereby lowering household net worth and raising leverage. To repair their balance sheets, households have been increasing their savings rate. The average savings rate of US households now stands at 5%, an improvement from the 2% levels of pre-2008. This balance sheet repair process has slowed consumption and, as a result, the recovery, as the US is primarily a consumption-driven economy. So, until such time the weakness of household balance sheet is resolved, the recovery will continue to falter. The problem in the US is probably more dodgy than in the European Union though, fortunately, the market is not focusing on the US, yet. Markets in general tend to be a bit myopic and the problem with the US is more long-term concerning the sustainability of government debt. If financial markets were to get apprehensive about US sovereign risk as much as they are about Greece or Spain, it would have serious consequences to the US and the global economy.
What can and should policymakers do Policymakers need to shift the focus from treating just symptoms of the crisis to dealing with its underlying causes, which would help resolve the current crisis of confidence. Rising sovereign risk, weak banks and the spill-overs between them have no quick-fix solutions and need to be tackled through comprehensive balance sheet repairs.
Public balance sheets in the US and in some countries in the European Union need to be bolstered through credible medium-term fiscal consolidation strategies. Banks need to cope with the spill-overs from sovereign risk by building adequate capital buffers. This is especially required of those who are very reliant on wholesale funding and are exposed to riskier public debt. Private sources of capital should be tapped. But in those cases where this is not possible or not sufficient, the weak banks need to be restructured or resolved without the use of public funds.
The lack of sufficiently decisive policy action has abetted the current crisis of confidence. While the path to sustained recovery has considerably narrowed, it has not disappeared. It is still possible to restore global financial stability and sustain the recovery,
but for this the developed economies need to act now and need to act boldly. The future of our interconnected economies is at stake.
The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance