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Bank stability is the key to recovery from recession

By Anatole Kaletsky , The Times
March 16, 2009

This time France and Germany are right — and America is wrong. To the extent that there was a real transatlantic difference of opinion at the G20 finance ministers' meeting this weekend, the Germans and French had economic logic on their side in resisting American demands for extra fiscal stimulus and trying to focus the discussion on strengthening the big global banks.

For while there may be a case in the future for additional tax cuts and public spending programmes to boost economic demand, the immediate priority must be to restore the stability of the world financial system and to persuade or force banks to start lending again to non-financial businesses and consumers.

Until the banks return to something like business as usual — which does not mean the insanity of the 2004-06 boom years but the normal availability of credit on sensible terms to sound borrowers — additional fiscal stimulus will not do much good. If, on the other hand, the banks were stabilised and the moderate reduction of credit that is still required were allowed to proceed in an orderly manner, as was broadly happening until the collapse of Lehman, then the world economy would probably emerge from recession in the next six months or so, without any need for further macroeconomic measures.

Starting with the last point, Angela Merkel was right to remind the world that Germany's fiscal easing, at 4.2 per cent of GDP over two years, is broadly similar in size to the $800 billion stimulus plan passed by the US Congress last month, since the latter figure follows America's misleading accounting conventions by estimating the total increase in the US budget deficit over a ten-year period. Moreover, as the German Chancellor noted, the German and American fiscal programmes, will go into effect only next month. It is, therefore, ridiculous to suggest that these measures have already proved ineffective and that more stimulus is required. Gordon Brown made the same point even more forcefully at his press conference with Mrs Merkel, when he observed that that the G20 countries had already agreed the “biggest fiscal stimulus in history” while their central banks had implemented the biggest interest rate cuts in history, as well as providing their financial systems with unprecedented public support.

Far from betraying a deep disagreement, or even a “row” over fiscal stimulus, as some of the weekend media reported, the German and British positions seemed to be in total agreement on this crucial point. The US attitude, as expressed privately at the G20 meeting, also appears to have been much closer to the German position than implied by last week's public spat between Larry Summers, the White House economic supremo, and Jean-Claude Juncker, the Luxembourg Prime Minister and official spokesman for the eurozone. Both Mr Summers and Mr Juncker have become notorious for belligerent public comments about their counterparts on the other side of the Atlantic. But luckily, the reality of the European-American economic co-operation does not depend on the personalities of these two notoriously prickly individuals.

Having said all this, there are two genuine sources of tension in the G20, which have nothing to do with the US “demand” for more European fiscal stimulus — and these will have to be resolved to avoid an embarrassing failure at the London summit on April 2.

The more widely publicised, though less important, relates to the European attitudes to financial regulation. Every G20 government agrees in principle with Mr Brown's call for fundamental regulatory reforms that would put all “systemically significant” financial institutions under some kind of supervision, whether they are banks, hedge funds or private-equity partnerships and wherever in the world they are legally based. But when it comes to the purpose of such regulation, the Anglo-Saxon and European positions sharply diverge. The French and Germans essentially want to make life as difficult and expensive as possible for hedge funds, private-equity investors and other financial institutions that they see as speculative or focused on short-term trading.

The British and Americans believe, by contrast, that these speculative investors play a very important role in oiling the wheels of international finance and improving the allocation of capital around the world — as well as generating a lot of wealth and tax revenues in London and New York. Moreover, the hedge funds have played almost no role in the present financial crisis. The worst problems have all been created by the world's most regulated financial institutions: US, British and continental European commercial banks, including several German banks, which were not just closely regulated but government-owned.

Finally, as British and American officials point out, the timescale for regulatory reforms is totally at odds with the urgency of the present economic crisis. Reforms that will take years to negotiate must not be allowed to distract attention from the decisions required immediately to avert a global depression.

The second area of disagreement is much more practical than the philosophical tension over financial regulation — and it is an area where international criticisms of US policy are fully justified.

Christine Lagarde, the French Finance Minister, put this issue bluntly in her pre-G20 statement last week, when she said that the US was demanding more action from the rest of the world because “they were the last ones to put in place their plan and they are facing a bigger crisis”. It was “imperative” for the United States to stabilise its banking system. Another urgent step, Mrs Lagarde added, was to reform the misguided accounting standards that were introduced only a few years ago and began immediately to magnify financial instability, just as their critics had warned. “We need to partially go back to a system of accounting based on historic values,” she stated. But in order to do this, governments would have to have the self-confidence “to disregard the reservations of the International Accounting Standards Board”.

The trouble is that the US Government seems incapable of deciding on the measures required to support its banking system — or even on minor technical changes, such as accounting reforms, which could be implemented at no economic or political cost. As Mrs Lagarde noted: “The successive announcements by Tim Geithner, the US Treasury Secretary, gave markets an impressionist sentiment. If they reacted badly, it is maybe because they sense the unfinished side of these plans.”

Mrs Lagarde was right. The European banks, although they have lost almost as much money as their US counterparts in the past two years, are seen by investors and creditors as far sounder. And while the eurozone has been hit even harder than the US and Britain by the global recession, European business is not being strangled by the tightening of bank credit. The reason is simple — European governments have been more decisive and explicit in supporting their banking systems.

The result is that even the banks in the weakest European economies — Ireland, Austria and Greece — are seen by the markets as much safer than the biggest US financial institutions, such as Bank of America and GE Capital. The reason for this absurd dichotomy is clear: the US Government has been so ambiguous in its financial policies, and changed the rules so many times to the detriment of creditors and investors, that nobody knows whether to believe Washington's promises of support for America's biggest banks.

As long as this situation persists, there can be no hope of restoring order to the global economy. The main obstacle to any concerted effort to revive the world economy is not European complacency. It is the baffling indecision in Washington.

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