Western world still haunted by zombie banks

The UK is the country “most susceptible” to having its economic recovery derailed by a credit shortage. That was the verdict of last week’s Global Financial Stability Report from the International Monetary Fund.

The gap between our massive public and private sector borrowing needs and what lenders will actually stump up amounts to a colossal 15pc of GDP this year and next, the IMF boffins calculate, compared to 3pc in the eurozone and 2.4pc in the US.

Spiralling public borrowing will also push up interest rates, the IMF reminds us, undermining a fragile economic upturn. History suggests a 1 percentage point increase in fiscal deficits, if maintained, generates a 0.3 percentage point rise in long-term rates.

The UK’s deficit is headed for 12pc of GDP, up from just 3pc in 2005. Do the math, if you dare. Keep in mind also that the rates firms and mortgage-holders ultimately pay are generally some way above long-term money market rates – particularly, as now, when the banks are doing everything possible to push the costs of previous mistakes onto their so-called customers.

Reading the IMF’s report it struck me that the UK and much of the Western world now faces what economists used to call “crowding-out”. When I first studied economics in the 1980s, we were taught that high public borrowing squeezes the private sector’s ability to access finance – not only in absolute terms, but by pushing up rates for everyone.

After all, that’s what had happened the decade before. “Crowding out” is a major reason the UK suffered such a dearth of enterprise and investment in the 1970s, causing feeble growth and high unemployment. And of all the world’s major economies, it’s the UK that’s now vulnerable to the same disease – given our massive fiscal deficit. The verdict on the UK’s fiscal position was a mere footnote, though, among some far more grave IMF warnings.

This column has often argued that true recovery won’t happen until Western banks “fess-up” their sub-prime losses. As long as our banks refuse to face reality and write down their multi-billion dollar positions in toxic “sub-prime” waste, parking them instead off-balance sheet, credit markets will remain in torpor, firms will be starved of working capital and jobs will keep being lost.

It’s because banks are harboring massive opaque losses that they won’t lend freely to each other, so gumming up the wheels of finance on which our economy depends. More than that, until banks take the write-downs, and the inevitable restructuring and mergers that come with them, they’ll continue shoving money into their bottomless sub-prime pits, allowing loan books to contract even further.

Some say we’re out of this crisis. This is merely a “V-shaped recession”. Such wishful thinking needs to be tempered by the Fund’s estimate that while banks around the world have recognized around $1,300bn of sub-prime and related losses since 2007, there’s at least another $1,500bn to come.

Why “at least”? One reason is that banks go to endless lengths to disguise their losses – even to the IMF. These numbers are also partially dependent on share prices. If the FTSE-250 falls, for instance, then UK bank losses from sub-prime and other bad loans get even worse. It’s my view that most Western stock markets are now way above fair value – pumped-up as they are by a combination of hope, hype and short-term government cash.

Banks in the U.S. have recognized 60pc of their anticipated losses, says the IMF, while those in the UK and Eurozone have “fessed-up” 40pc. No wonder the Fund is warning of a “significant” risk of another downward lurch in the global recession.

The UK’s political classes, no doubt, will dismiss all this as yet more doom and gloom from a typically “dismal scientist”. But even if these lingering sub-prime liabilities don’t cause another systemic financial crisis – a big if – their on-going presence on bank balance sheets, and our continued policy of keep such banks alive using the oxygen mask of government bail-outs and printed money, will squeeze the life out of our economy for years to come.

When I argue against quantitative easing and debt-fuelled Keynesian boosts, I’m often met with a glib one-word response: “Japan”. Many “experts” have been brain-washed into thinking that unless we print money with abandon and prostrate ourselves with more state debt then the UK, too, will endure “a lost decade”.

This is dangerous nonsense. Japan didn’t stagnate in the 1990s because it refused to do QE and a massive fiscal expansion, or because it waited and did both half-heartedly. Japan suffered a ten-year slump precisely because its too-big-to-fail, politically-connected “zombie” banks were allowed to stagger on, acting as a massive drain on the broader economy. And, much as it pains me to write it, that’s precisely what’s happening in the UK.

NO TIME FOR OSBORNE TO TALK WITHOUT SPEAKING

“The immediate priority is to preserve Britain’s credit rating with a clear plan to deal with our huge budget deficit”. So said George Osborne back in June. So what has the Shadow Chancellor since said about our dire fiscal predicament? Absolutely nothing.

Osborne has been talking a lot about the UK’s woeful public finances. He’s become adept at pointing out “we’re in this mess because Gordon Brown racked up so much debt”. What a shame the Tories didn’t grasp that three or four years ago, when Brown’s reckless borrowing was sowing the seeds of this fiscal crisis. Some of us shouted it from the rooftops.

Back then, rather than challenging Labour, the Tories did what their financially illiterate PR folk told them to do. They repeated ad nauseum they would cut debt and still match Brown’s spending by “sharing the proceeds of growth”. Under the Tories we could have it all – high spending and fiscal responsibility. It’s precisely because the incoming government spouted such vapid nonsense for so long on fiscal policy, that they now need to show they mean business.

Yet while Osborne talks a lot about fiscal policy, he says nothing. I’ve heard the speech about Labour “failing to fix the roof when the sun was shining” at least half a dozen times. Meanwhile, the UK’s solvency rests on a gilts market itself reliant on money printed by the Bank of England. This fiasco is unsustainable – so it will not be sustained.

In the first five months of the financial year, the UK borrowed £65bn – two-and-a-half times more than in 2008. At this rate we’ll borrow £220bn in 2009/10 - £50bn more than predicted in April’s budget. With tax receipts down 11pc year-on-year, we may in fact need £250bn of finance this year, with borrowing of £200bn+ for the next two years as well.

The markets simply won’t have it. Our national debt is set to breach 100pc of GDP – from 38pc a couple of years ago. What’s fatal, though, isn’t the size but that rate at which our debts are rising.

At his party conference in Manchester, Osborne needs to shove the fiscal debate forward, forcing the government to take radical steps in this autumn’s pre-budget report.

The Shadow Chancellor needs to say something, not just talk. After all, as he told us in back June, preserving the UK’s credit rating is absolutely the “immediate priority”.

Liam Halligan is Chief Economist at Prosperity Capital Management