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  • The Week on the Hill

When they met last week in Pittsburgh, President Obama and the other leaders of the world's big economies felt pleased with themselves, and let it show. They said that the worst is over. Economic recovery is under way. Problems remain, but these can be dealt with calmly. No need to rush at this.

Less than a year ago, the prevailing mood was barely suppressed panic. Today it is, "See how well we did." The G-20 communique declares that the world is in "transition from crisis to recovery." It goes on, "When we last gathered in April, we confronted the greatest challenge to the world economy in our generation. Global output was contracting at a pace not seen since the 1930s. Trade was plummeting. Jobs were disappearing rapidly. Our people worried that the world was on the edge of a depression.... [Last spring] our countries agreed to do everything necessary to ensure recovery, to repair our financial systems, and to maintain the global flow of capital." New paragraph: "It worked."

When you think about the part that bad policy played in causing the crunch to begin with, and about how little has been done even now to stop the next slump, this is all a bit much. Yes, the instant response to the crisis got some big things right, despite the criticism it aroused at the time. Give some credit where it is due. A global recovery does seem to be gathering pace, which is good. But the recent sense of urgency over fixing some deep remaining problems has started to fade, which is not good.

How strong a recovery might this be? Most forecasters expect it to be tepid. Households in many countries have watched their savings collapse because of slumping stock markets and falling house prices. Both trends are reversing -- Wall Street has had a surprisingly strong rally -- but there is a lot of ground still to be made up. So for the time being, the argument goes, saving will be high and consumer spending, a key driver of economic expansion, will be muted. Thinking about that, about fragility in the beaten and bruised financial system, and about other factors that might brake the recovery, some economists expect a period of stagnation, or even a "double-dip" recession, rather than strong or moderate growth from here on.

Yet a more optimistic view is also starting to emerge. Michael Mussa, a widely respected economist and senior fellow at the Peterson Institute for International Economics, argues in a new paper (available at www.iie.com) that the rule of thumb that says steep recessions are followed by strong recoveries is going to apply in this case as well.

Mussa expects year-over-year growth of 4 percent for the United States in 2010. This implies, as he says, that the cumulative rise in U.S. output from the trough of the recession in the second quarter of 2009 to the end of 2010 would be 7 percent -- hardly out of the ordinary after a recession of this severity, yet more than double the growth expected, on average, by the 50 forecasters in the most recent Blue Chip survey. According to the consensus forecast, U.S. unemployment will exceed 10 percent and stay there through 2010. If Mussa is right, the unemployment rate will drop below 9 percent by the end of next year.

Needless to say, a lot depends on whether Mussa is right. How far the Obama administration can press its domestic policy agenda; the outlook for taxes and public borrowing; the prospects for the Democratic Party in next year's midterm elections; and a great deal else could turn on the strength of the recovery.

Mussa is an outlier, but his optimism is not implausible. His thinking is simply that the recovery will be normal -- nothing more outlandish than that. He looks at the reasons for believing that the recovery will be slower than usual and finds them unpersuasive. For instance, he says, the popular idea that recoveries following financial crises are especially weak is a misreading of history. Scandinavia's oft-cited puny recoveries of the 1990s were hobbled by new external factors (the collapse of the Soviet empire; Europe's exchange-rate crisis), not by the legacy of financial stress. Mexico after 1995, the Asian economies after 1997, and Argentina after 2002 all managed strong recoveries in the aftermath of financial collapse. And this works both ways: Strong recovery, if it happens, is an effective treatment for financial-sector wounds.

Let us hope that Mussa is right. He emphasizes, however, that even if he is, the G-20 still needs to get moving on steps to avoid the next crisis. The smiling and backslapping at the Pittsburgh meeting point to a slackening of momentum.

The governments do deserve credit for delivering strong fiscal stimulus -- achieved more by letting budget deficits soar under the impact of the slump than by passing new (and mostly slow-acting) fiscal packages. Monetary policy also moved quickly and powerfully to support demand. The various bank-rescue plans, messy and ad hoc as they may have been, look so far to have worked as intended: Financial paralysis was avoided, financial systems have been stabilized, and the supply of credit has resumed. But avoiding a repetition of this severe slump, with all the damage it has inflicted and continues to inflict, requires further action now.

The danger is obvious. The stronger the recovery, the more relaxed governments are likely to be -- and the less likely it is that needed changes will be made.

The most important unfinished business is reform of financial regulation -- and the most crucial piece of that fix is capital requirements. To prepare the way for the Pittsburgh summit, the G-20 finance ministers met in London, and Treasury Secretary Timothy Geithner presented some good proposals. The details are complex and troublesome, of course, but the basic principles of what needs to be done are actually quite simple and not in dispute.

Capital is the cushion that a bank holds against its loans going bad. In the form, for instance, of shareholders' equity (the purest kind of bank capital), it can be drawn down to cover losses. The bigger its reserves of capital, the less likely a bank is to fail -- and the less likely it is that the government will be forced to bail it out at huge expense to taxpayers to protect the system as a whole.

The capital market is global, and its rules should be too. Fixing this is the G-20's biggest challenge.

Regulators have let banks hold less and less capital over the years, reasoning that bankers were competent managers of financial risk. How quaint that now seems. In effect, banks were allowed to decide for themselves how much capital was needed, and even what counted as capital for regulatory purposes. Capital has a low yield -- which is why a higher capital requirement is like a tax on banks' lending -- and governments were standing by to rescue them if necessary. So they cut corners. You know the rest.

Geithner said that banks need to set aside much more capital. Big banks should reserve proportionally more than small banks. The new requirement also needs to be "counter-cyclical": Banks should have to set aside proportionally more capital when their lending is increasing quickly. There should be an overall leverage ratio, too, as a global check on capital adequacy, even if proper amounts of capital have been reserved against specific types of "risk-adjusted" lending. And there should be a liquidity requirement so that banks have a line of retreat if their ability to borrow short-term is compromised.

Geithner is right. All this needs to happen, and everybody knows it. Banks are grumbling at the prospect, but none has offered a principled argument against it.

The Pittsburgh meeting affirmed the need for this new regime, but the timetable for reform is vague and the G-20 partners have different ideas about what happens next. Right now, U.S. banks are better capitalized than many of their European counterparts, so Europe is complaining that it will be harder for its banks to execute Geithner's proposal. This disagreement is liable to slow the introduction of new rules and might lead to their being watered down.

Unfortunately, this regime is going to work well only if governments act jointly. The capital market is global, and its rules should be too. International differences in regulatory treatment will help banks lobby against stricter supervision. They will say that the new approach makes them uncompetitive, a line that has invariably worked up to now.

This is the G-20's real challenge. Forget the rest -- rebalancing global growth, rebuilding the International Monetary Fund, coordinating fiscal and monetary "exit strategies," and all the other stuff name-checked in the communique. Helpful though some of that may be, none of it is indispensable (and some of it is impossible). Stricter bank capital requirements are in a category of their own. Judge the G-20 -- and place your bets on the next financial crisis -- according to what, if anything, it achieves on this.