The global economy is trapped in a maelstrom of vicious cycles and the best way to halt this downward spiral is to recapitalize banks so they no longer burden governments and can return to their role of supporting economic growth, the Bank for International Settlements (NASDAQ:BIS) said.
Major parts of the economy - households and firms, governments and banks - must improve their financial positions but they are stuck in vicious cycles: As households and firms cut debt, it hampers the recovery of governments and banks. As governments cut spending, it hurts households and banks, and as banks recognize losses, they have less money to lend.
"Each sector's burdens and efforts to adjust are worsening the position of the other two," said BIS, known as the central bankers' bank, in its annual report.
Central banks have been called to the rescue, slashing the cost of money to historic lows and making sure there is plenty to go around. Real interest rates are negative in most major economies and the balance sheets of central banks has risen to some 30 percent of global economic output, double the level a decade ago, as they print money to buy government bonds and keep interest rates low.
"Central banks find themselves in the middle of all of this, pushed to use what power they have to contain the damage: pushed to directly fund the financial sector and pushed to maintain extraordinarily low interest rates to ease the strains on fiscal authorities, households and firms," BIS said.
But the effects of central banks' loose monetary policy is limited as households and banks are taking advantage of the stimulus to pay off debts rather than boost spending, holding back the recovery.
"By itself, easy monetary policy cannot solve underlying solvency or deeper structural problems. It can buy time, but may actually make it easier to waste that time, thus possibly delaying the return to a self-sustaining recovery," it said.
BIS' call for banks to shore up their balance sheets comes as Spain is set to make a formal request to euro zone finance ministers for as much as $100 billion to recapitalize its banks, which financed a huge building boom that went bust.
Illustrating the destructive feedback between banks and sovereigns, Madrid's bailout of its banks has put pressure on its own finances, leading to speculation that Spain may join Greece, Portugal and Ireland in restructuring its debt.
With financial markets gyrating with each new twist in the dance of euro zone politicians, BIS cautioned that other countries around the world could face the same fate if they fail to take action.
"But at its root the European crisis is a potential harbinger, a virulent and advanced convergence of the problems to be expected elsewhere if policy fails to break the vicious cycles generated by the global weaknesses," BIS said.
EXPLODING GOVERNMENT DEBT
While the first step in breaking the vicious cycles is to recapitalize banks, governments can no longer postpone the arduous task of slashing debt.
"Unsustainable debts were ultimately the source of the financial crisis, and there is little evidence that the situation has become much better since," BIS said.
Government debt in advanced countries has on average exploded to more than 110 percent of annual economic output from some 75 percent in 2007, and annual deficits are now 6.5 percent of output on average, up from 1.5 percent.
The strain on government coffers has lead to the loss of a risk-free status for many sovereigns, distorting markets and raising the cost for private borrowers.
"In most advanced economies, the fiscal budget excluding interest payments would need 20 consecutive years of surpluses exceeding 2% of GDP - starting now - just to bring the debt-to-GDP ratio back to its pre-crisis level. And every additional year that budgets continue in deficit makes the recovery period longer," BIS cautioned.
Aware of the political sensitivity of the issue, BIS tiptoed around the question of how governments should cut deficits but added that long-term measures should be forceful and credible, even if that means painful measures now.
"Governments in the advanced economies will have to convincingly show that they will adequately manage the costs for pensions and health care as their populations grow older. Spending cuts and revenue increases may be necessary in the near term as well," BIS said.
Countries in the deepest financial hole will have to be much more aggressive and quickly reform their public sectors to regain the trust of financial markets.
"The road back to risk-free status for sovereigns is a long one. Some countries have already run out of options and will have no choice but to take immediate steps to restore fiscal balance. Others will need to strike the right balance between long- and short-term measures to be successful. A key challenge for governments as they strive for that balance is to avoid losing the confidence of investors," BIS said.
THREAT TO EMERGING MARKETS
The intractability of the three, connected cycles is hindering reform, not only in advanced economies but also in emerging economies, where rapid growth is masking underlying weaknesses in their government accounts, much as they did in advanced economies before the financial crisis.
"If recent signs of a slowdown persist, the fiscal horizon of emerging market economies could darken quickly," BIS said.
Emerging economies could soon face their own version of a boom and bust cycle if they don't shift their reliance on exports and credit towards domestic demand, especially now that exports are likely to be less buoyant.
Unfortunately, there are no quick fixes to the daunting challenge of solving deep structural problems, something many investors and consumers realize.
"All of this is understood by advanced economy consumers who are reducing debts and are reluctant to spend; it is understood by firms postponing investment and hiring; and it is understood by investors wary of the weak and risky outlook - why else would they accept negative real interest rates on government bonds in many advanced economies?"
And yet, BIS sees a ray of hope on the horizon, even in Europe, where BIS admitted the crises of confidence makes it even tougher to solve the problems.
"Fixing structural problems during a confidence crisis is both more difficult and more important than it is in better times. It is more difficult because unemployment is already high and public funding that could mitigate short-term adjustment costs is scarcer. It is more important because confidence is unlikely to return until authorities have got to grips with structural weaknesses," BIS said.
It called for the euro zone to implement a banking union with unified bank regulation, supervision, deposit insurance and resolution to complement the existing pan-European financial market and pan-European central bank.
"That approach will decisively break the damaging feedback between weak sovereigns and weak banks, delivering the financial normality that will allow time for further development of the euro area's institutional framework," BIS said, adding its support to the European Central Bank.
Restoring the health of the banking sector in Europe and elsewhere is critical to end the "destructive interaction" with households and governments, BIS said, adding that a healthy banking sector would clear the way for governments and households to tackle their debt pile.
"Only then, when balance sheets across all sectors are repaired, can we hope to move back to a balanced growth path. Only then will virtuous cycles replace the vicious ones now gripping the global economy," BIS said.