The spring-like whiff of optimism about the “green shoots” of economic recovery is, as they say in American football, a head fake. All economic contractions end eventually, and this one may be diminishing, but sustainable recovery is something else. It is impossible to envisage a recovery until such time as politicians are prepared to take on the financial establishment, and grab the solvency of the banking system by the scruff of the neck.

In some ways, our crisis is already worse than the Great Depression. Global industrial production and exports have fallen more in the last year, than in the year to mid-1930. But one of the many lessons from the Depression, and other banking crises, is the over-arching need to stabilise the financial system as a precondition for stability, and then recovery. Historically, the reasons that governments delay or obfuscate in this task lie in both failure to realise the insolvency nature of big financial crises, and a failure to tackle vested financial interests.

When William Jennings Bryan concluded one of the most important speeches in US political history in 1896 with the words, “You shall not crucify mankind upon a cross of gold”, he wasn’t just making an esoteric point about the pro-gold-standard lobby. He was embracing the cause of debt-ridden and credit-starved farmers, and other borrowers, against urban, internationalist and, above all, financial interests. The 1930s financial crisis was due, at least in part, to the consequences of the prior return to the gold standard, championed by vested financial interests after 1918.

Fast forward. Since the 1980s, the financial sector’s share of profits, jobs and GDP growth all expanded to an unprecedented degree. Economic orthodoxy emphasised deregulation, leverage came to be the new alchemy, and a laissez-faire financial system was allowed to develop, facilitating excessive debt growth in the West, and unchecked expansion in wholesale funding. Instead of finance being the servant of the economy, the latter became a slave to finance and debt-financed growth. We may have had no equivalent to the gold standard as such, but in the sense that it symbolised an approach to economic organisation, championed by vested interests, we did — and, despite change that is afoot, still do.

Nowhere is this more apparent than in the approaches taken to fix the financial crisis. Excessive debt creation in the financial sector that supported unsustainable asset inflation is what got us into this mess. Debt resolution, via default, restructuring, debt-for-equity swaps, and probably some inflation, is the essential way out, but progress on this front has been far too slow.

Bank recapitalisation, asset purchase and guarantee schemes, and fiscal measures have all been deployed, amounting to 40 to 50 per cent of GDP in the UK and the US, and 15 to 20 per cent of GDP in the eurozone. Yet, the banking system remains on life-support. It is labouring under the deadweight of bad assets, and the need for more capital. The International Monetary Fund is now expected to raise its estimate of global credit losses to about $4,000 billion. About three quarters of the losses are in banks, which have had more than $1,000 billion of capital injected, and admitted comparable losses, and which still need more than $400 billion this year alone, to maintain required capital levels.

The size of losses and bad assets is so large that it is barely conceivable that banks’ balance sheets can be repaired properly as things stand. Governments are committing taxpayers to huge costs (and future taxes), while many large banks are at risk of becoming the zombie institutions we said that we would never copy Japan in creating. The US and UK plans to deal with bad assets might work in a typical downturn, but in this recession, the chances are not good.

Unwilling to seek more money for banks or to nationalise, governments are taking on banks’ huge liabilities, but not managing or disposing of their assets. They look to the private sector to buy up bad assets. Non-financial companies, like GM, can be threatened with bankruptcy and a badly needed swap of debt for equity, but seemingly, this won’t work with banks. The reluctance to oblige unsecured creditors to take their share of loss, or to provide a framework for them to become the new owners, simply underwrites zombie banks that sour the environment for their better peers. The sooner we deal properly with banks and their assets, the sooner banks can return to normal intermediation functions.

Making credit markets work better won’t create more creditworthy borrowers or force debt-averse households and firms to borrow. Printing money to facilitate more spending and debt repayment isn’t preventing hoarding of cash by banks and households. Real or imagined constraints over fiscal policy mean that our best, indeed only, hope for sustainable economic recovery is to capitalise banks properly, sever the bad assets from balance sheets and prioritise viable entities and essential lending from those that are neither.

This may require, among other things, further nationalisation or receivership, as necessary. We are now at the stage where strong political courage is required.

Hoping for an economic recovery to turn up simply won’t do.

- George Magnus is Senior Economic Adviser at UBS, the investment bank, and author of The Age of Aging: how demographics are changing the global economy and our world (October 2008)

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