Economic stimulus, including that planned by the Obama Administration, cannot alone pull the world out of the current tailspin and more needs to be done to fix the underlying causes of the crisis, particularly in the banking sector,IMF Managing Director Dominique Strauss-Kahn said on Monday. Robert Zoellick, President of the World Bank, also said on Monday that pumping government money into the economy was not enough by itself.

"If there's not a restructuring of the banking system, then all the money that you can put into [monetary and fiscal] stimulus will just go into a black hole,"Strauss-Kahn told a panel discussion at Georgetown University in Washington DC.

Restructuring the banking system would involve fully recognizing losses, segregating bad assets held by banks, preferably through a public institution that can take them over, and downsizing the sector "which means that it has in some way to shrink, that some part of it has to disappear." To do this would need strong public intervention.

While a lot had been said about recapitalising banks and recognizing losses, not enough had been done so far and the sector continued to undermine confidence, he told the panel discussion organized by the Financial Times and Georgetown University. Panelists also included Roger Altman, Chairman of Evercore Partners and a former U.S. Deputy Treasury Secretary, and William Gale, Director of Economic Studies at the Brookings Institution.

Gale reinforced the IMF Managing Director's remarks. "We have to address the situation in the financial sector. This isn't the usual recession. This is the very deep, very long, very difficult-to-get-out-of type of recession," he said.

 “If you have fiscal stimulus without fixing the banking system, it will be like a sugar high,” Robert Zoellick told the Financial Times.

“There is a lot of good economic advice out there,” he said.“The challenge is the political leadership.”

Strauss-Kahn said the Group of 20 big economies had failed to fulfill promises to co-ordinate global action to boost the economy and rebuild shattered banks.

At the G20 meeting in November, “governments spoke with one voice”, he said, pledging to recapitalise troubled banks, remove toxic assets from the financial system and co-ordinate fiscal stimulus. “But very little has been done and time is running out,” Strauss-Kahn said. “It is moving very slowly.”

Spreading crisis

Strauss-Kahn, a former finance minister of France who took over as head of the IMF in November 2007, has said that the world faces a deepening economic crisis, with the slowdown in advanced economies now spreading to major emerging markets such as China, India, and Brazil.

The IMF will significantly adjust downward its forecast for world growth for 2009 when the 185-member international institution announces a revised assessment of the global economy on Wednesday, January 28th. In an update released last November, the IMF had said that advanced economies would see a contraction in output in 2009—the first since World War II—but that growth in major emerging markets would still enable the global economy to advance by 2.2 percent in 2009.

Politically difficult

Strauss-Kahn recognised that putting more public money into the banking sector to restructure it can be unpopular politically."But the reality is that one dollar spent in restructuring the banking sector today is much more useful to achieve recovery than the same dollar spent on bridges, hospitals etc."

The reason was that troubles in the banking sector were continuing to undermine the real economy. "Roots of the crisis are in the linkages between the financial sector and the real economy. We are experiencing a very adverse feedback loop between the financial sector and the real economy."

Fiscal stimulus, plus monetary measures such as very low interest rates, would not be enough without tackling the troubles in the banking sector. Only then could confidence be restored and recovery get under way. "As long as confidence does not come back, you can put as much money as you want into the economy, you won't have this recovery."

Removing toxic assets

The IMF has experience of 122 banking crises, Strauss-Kahn told the students."One thing is constant, until all the losses have been recognized—not only from real estate, but also [others] resulting from the downturn in the economy—not until all the banks have been cleaned up can we find any way for recovery."

The Managing Director said that Sweden provided a good example of how to tackle a banking crisis. In the 1990s, Sweden had set up a special public company to take over the toxic assets and remove them from the banking system. Later, after the system had recovered the assets were sold off and the company had ended up recovering some public money.

Strauss-Kahn said it was probably better if a public company took over the bad assets, though another solution was for the assets to be segregated within a bank.

Similarly, Altman said he also favored going back to the original purpose of the relief package launched in the United States in October 2008, known as the Troubled Asset Relief Program (TARP). TARP allows the United States to purchase or insure up to $700 billion of "troubled" assets, but it was later revised to enable capital injections into the banking system and other forms of relief.

"We should remove large chunks of these toxic assets, put them under the administration of a special public company, which could then dispose of them over time," Altman said. But he recognized that TARP was not a popular program "So the politics are difficult and are only going to get tougher." But more money would be needed to clean up the system.

Strauss-Kahn pointed out that while TARP was a US program, the crisis was global and thus needed global solutions. Cooperation with other countries was vital to ensure coordination around the world. More needs to be done to make good on the promises of the leaders of the Group of Twenty (G-20) leaders who met in Washington last November to tackle the crisis.

China's currency

Asked to comment on whether he thought that China's currency remained misaligned, Strauss-Kahn said that the IMF had been straightforward about the value of the renminbi, stating on several occasions that it needed to appreciate. But in the middle of a crisis, the world needed China's growth. The question was how to get China to shift policy and not to get into name-calling, a reference to the US Treasury Secretary Timothy Geithner, who said at his US Senate Finance Committee confirmation hearings last week, that China was a currency manipulator.

Strauss-Kahn said that the Chinese currency was still significantly undervalued from a medium-term perspective and that China recognized that it was in its own best interest to shift away from export-led growth to domestic-led expansion. Beijing realized that it was necessary to rebalance the economy and change policy. But this could not be done overnight.

Finfacts Article Jan 22, 2009: Dr. Peter Morici: Fixing the Banks