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It looks like a bank aggregator for bad assets is pretty much a done deal. David Axelrod said Sunday that we should expect a new approach within a few days, and leading reporters (New York Times, Washington Post) have discerned that this is likely to include a "bad bank" into which troubled/toxic assets can be disposed.
We don't yet know the details, and these matter a great deal (for the taxpayer and for the gradient of the road to recovery). But it's not too early to think about the global implications, at least in qualitative terms.
The backdrop, of course, is that the international banking environment is very unsettled at present, probably worse than any time since mid-October. Ireland just had to nationalize its previously most aggressive mortgage lender (i.e., in Irish mortgages) and the UK seems poised to announce a further scheme for helping banks (and probably forcing them to lend, although the British property sector looks highly dubious). "Bad banks" are in the air, in all senses of the term.
Let's say the US launches a comprehensive bank recapitalization and balance sheet clean-up scheme, with broad support on Capitol Hill. This bolsters confidence in the US banking system, causing a rise in equity prices and—most important—a strengthening of debt, both for banks and perhaps for leading nonbank corporates. Three international consequences seem likely.
First, this move forces the rest of the G-7/G-10 and the eurozone to do the same, or something very similar. If we have very strong (and government backed) banks in the US and somewhat more dubious banks anywhere in other industrialized countries, money will flow into the stronger US banks. Think back to the consequences of the original infectious blanket guarantees in Ireland in October; the effects now would be similar. You can think of the UK's upcoming moves either as a smart way to get ahead of this, or as something that will further a destabilizing wave of competitive recapitalizations. The policy is good, but doing it without coordination across countries can trigger Iceland-type situations.
Second, if all major economies need to back the balance sheets of their banks, then we have converted our myriad banking sector problems into a single (per country) fiscal issue. Who has sufficient resources to fully back their banks? This obviously depends on (a) initial government debt, (b) size of banks (and their problem loans, global and local), and (c) underlying budget deficit. Ireland and Greece will be in the line of fire, but other weaker eurozone countries will also face renewed pressure. Officials are currently (slowly) trying to work through this predictive analysis, and there is some sketchy thinking about preemptive preparations, but events are moving too fast—and the international policy community again can't keep up.
Third, in some countries—particularly emerging markets but also perhaps some richer countries—the foreign exchange exposure of banks will matter. Here the issue will be whether the government has enough reserves to back (or buy out) these liabilities. The problems of Russia since September foreshadow this for a wide range of countries. The absolute scale of reserves does not matter as much as whether they fully cover bank debt in foreign currency. Most emerging markets face significant difficulties and need some form of external support in this scenario, particularly as both commodity and manufactured exports from these countries will continue to fall.
If, by great and fortuitous coincidence, the US and global recession is already at its deepest—as some in the private sector now hold—then we face a tough situation but the difficulties are manageable. However, our baseline view remains that the real economy is not yet stabilized, and hence we will see worse outcomes in Q1 and Q2 of 2009 than currently expected by the consensus. Such outcomes are not yet reflected in asset prices, and the problems for banks—and the implications for fiscal sustainability—around the world will mount.
Financial support for distressed countries within the eurozone, from the G-7, and across the G-20 will help. The scale may be beyond what the IMF can readily handle by itself. But this is a very big global fiscal problem, and the appetite for large-scale official rescue financing in the face of these problems remains uneven.
This posting also appears in Simon Johnson's blog, Baseline Scenario.
