AVOIDING A LOST DECADE FOR ECONOMIC GROWTH / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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JUNE 13, 2010, 12:43 P.M. ET.

Avoiding a Lost Decade for Economic Growth

By PETER EAVIS

If 2008 was the year of sheer panic, 2010 is shaping up into one of stubborn, slow-burning angst.

There is a feeling that a lot remains unfixed in the economy, even though governments have spent heavily and central banks have flooded their economies with easy money. If the forces of deflation and deleveraging still aren't neutralized, what can be done to stop them? Indeed, might the only workable economic approach be to let these forces play themselves out?

The case for doing this can arguably be seen in the banking system, where credit is contracting, despite government help. Bank loans and leases have fallen a brutal 10.5% since the end of 2008, adjusted for loans brought onto banks' balance sheets because of an accounting-rule change. They are even down 3.25% since the end of 2009.

Take Bank of America, whose Tier 1 common ratio—a regulatory measure of capital to assets—rose to 7.6% at the end of the first quarter, from 4.5% a year earlier. Yet that thicker loss buffer hasn't yet spurred loan growth. In the year through March, BofA's total loans and leases totaled $977 billion, flat with the year-earlier amount.

One reason for the lending freeze may be that the Bush and Obama administrations completed only half of the bank restructuring required. After applying a huge Band-Aid to the system, in the form of big capital injections, they didn't push a wholesale restructuring of bank balance sheets that might have involved big sales of questionable assets, including toxic loans.

Such asset sales would in theory speed up asset-price adjustments across the economy and get prices to a level from which they can rise sustainably. Right now, banks and borrowers may feel asset prices haven't adjusted fully. This adjustment is being distorted in key parts of the economy, which may put a crimp on bank lending for years.

In Japan, a similar economic drag persisted because a much-needed restructuring of the corporate sector didn't occur. In the U.S., it is the household sector and real estate—where banks have most of their loan exposures—that need more of an adjustment. For example, because of huge government support, it is almost impossible for anyone to tell if property prices are close to a natural bottom.

If assets such as houses were to find this firmer floor, banks may feel much better about taking them as collateral for new loans. Meanwhile, borrowers would be more likely to take out loans to buy lower-priced assets.

Of course, instigating this sort of restructuring, and generating further asset-price weakness, would mean more losses on already-made loans. But it may turn out that taking those losses is necessary to avoid a Japanese-style lost decade for economic growth.

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