Although the current global economic gloom
continues to cause sleepless nights for many CEOs, a worldwide
depression is now “very unlikely” and it’s a “likely scenario” that the
US economy could start to recover from its recession by the end of this
year, says Ilian Mihov, INSEAD professor of economics.
warrants the optimism? For starters, two major economic imbalances in
the US - the ratio of house prices to income per capita and domestic
consumption to income ratio - could be unwound by year-end, as
over-inflated house prices fall and debt-fuelled spending declines amid
the economic shakeout.
“In other words … the foundations for recovery would have been set,” says
Mihov, a former doctoral student of Federal Reserve chairman Ben
Bernanke. Mihov shares the Fed chairman’s optimism of the start of a
recovery by year-end although he has concerns that the US
administration may not be moving quickly enough to tackle the banking
speaking to INSEAD Knowledge ahead of US Treasury Secretary Tim
Geithner’s unveiling of three federal programmes to clear toxic assets
from the balance sheets of banks. Under the three-part 'Public-Private
Investment Programme', the government will offer private investors
immense amounts of cheap public financing to match every dollar of
private investors’ capital.
such an ambitious partnership between the government and private
investors, as much as US$2 trillion in real estate assets - which have
been instrumental in causing the financial crisis - could reportedly be
acquired. This could then unfreeze the credit markets and lead to the
normal resumption of lending activities by banks, paving the way for an
On the government’s earlier
US$787 billion stimulus package, which was passed by Congress in
February, Mihov says the move was “in the right direction” even if
efforts to rid the toxic assets from the balance sheets of banks have
been progressing slower than some were expecting.
handling the financial and economic crisis, the record of the first
hundred days of the Obama administration is mixed, Mihov says.
would say they (the Obama administration) are moving too slowly,
possibly from an idealistic point of view. You know the right actions
are .. and you want to implement them right away.”
“But of course the political process and the technical details of
these programmes are so complicated that it’s not possible to do it
faster than this. I’m not sure that anyone else could have done it
In recent weeks, President Obama and
Treasury Secretary Tim Geithner have come under fire from US lawmakers
and Wall Street for being slow in coming up with a detailed plan to
acquire toxic assets from banks to resolve the banking crisis.
in addressing the present economic downturn, current US fiscal policies
are “more aggressive” than those implemented in the Great Depression in
the 1930s, while the Federal Reserve has adopted a highly expansionary
monetary policy in providing liquidity to banks, Mihov says.
Mihov believes that the key to kick-start economic growth by
resuscitating the banks lies in the adoption of the so-called Swedish
model of the 1990s, whereby a “bad bank” is created by the government
to clean up the balance sheets of banks by acquiring their toxic
Indeed, it is crucial to resolve the
toxic assets, such as mortgage-backed securities, as they are a
“cancer” on the balance sheets of banks.
“If the financial sector doesn’t work then the economy is not going to recover,” Mihov told INSEAD Knowledge.
explains that the magnitude of the present financial turmoil was caused
in part by the willingness of the US government to allow the collapse
of investment bank Lehman Brothers, which was laden with toxic
mortgage-backed assets. This caused banks to stop lending because of
widespread uncertainties about the financial integrity of the financial
sector and fears about the withdrawal of funds by spooked investors,
which could lead to further bank failures.
we remove the toxic assets, then banks will have a big chunk of their
uncertainty removed and this would eventually lead to resumption of
So if a
“bad bank” is created by the end of April or early May, all the
conditions for an economic recovery would be in place by the summer or
in early fall, Mihov adds.
But banks are reluctant to dispose of their toxic assets in a falling
market because values will continue to plummet. Already, some
mortgage-backed securities are reportedly trading at around 40 cents on
the dollar, and this is driving fierce public debate about how toxic
assets should be priced. However, Mihov argues the debate is a
“non-issue”. He says the “bad bank” could buy toxic assets based on
their current market values. To entice banks to offload their toxic
assets, the “bad bank” could promise to return any profits arising from
the toxic assets when they reach maturity.
But if the “bad bank” incurs losses from holding the toxic assets to
maturity, then it could perhaps receive equity in the banks equal to
the amount of the losses. The value of the equity should be based on
the market value at the time of the purchase agreement.
although US taxpayers will likely foot a trillion-dollar bill for the
acquisition of toxic assets by the “bad bank”, the downside for
taxpayers in the long term would be limited.
“At the end of the day, in both cases (profits and losses), taxpayers
may gain because if these banks indeed survive 10 years from today, you
might be able to get stock in Citibank for US$2.50 (compared to) when
Citibank might be US$10.50 or even US$50 at that time (in the future),”