Global economic restructuring is needed, and that demands political determination and unity

The new CEO of the International Monetary Fund revealed an unstable economic future for the world during a recent speech.

Christine Lagarde addressed leading economists and central bankers on Aug 27 at the Kansas City Reserve Bank Economic Symposium held in Jackson Hole, Wyoming.

Bankers flock to this annual event to hear speeches by policymakers, as they tend to signal which direction economic policies are headed.

When Lagarde, who leads the organization that advises and supports national central bankers and finance ministers, described the world economy as entering "a dangerous new phase", she implied two things: that she intended to send an important signal, and she wasn't exaggerating.

The previous day, Ben Bernanke, the chairman of the US Federal Reserve, gave a speech against a background chatter of continued high US unemployment and weakening economic growth, which made it a particularly closely watched one.

The markets were hoping that the monetary authority would respond to signs of economic slowing by announcing another round of monetary injections. They were disappointed. Although he did not dismiss the possibility of further monetary assistance, Bernanke emphasized the economy will work out the issues on its own.

He said he was optimistic about the American economy as it is slowly healing from the severe wounds inflicted on it in 2008 by the financial crisis.

Although Bernanke didn't convey the degree of urgency that Lagarde did, both speakers agreed that actions by national central banks are reaching their limits in terms of addressing the world's economic problems.

The fundamental problems are structural. Now it's up to national governments to tackle the excessive debt and under-capitalized banking systems, which explain the chronic instability and weakness of Western economies.

On Aug 24, the cost of insuring against the default of leading European banks, such as BNP Paribas, Royal Bank of Scotland and Deutsche Bank, rose to more than 2 percent (or $200,000 per $10 million) higher than before the beginning of the 2008 crisis. For weeks, the shares of the European banks have been falling. The bans on short selling in France that greeted the signs of real stress failed to recognize the reality of the situation.

Banks have relied heavily on short-term loans from other banks to maintain their liquidity and meet their commitments. The drying up of inter-bank lending in the past week or two shows that European banks are losing trust in each other. They are thinking "if my bank is lying, the others must be lying as well".

In her speech in Wyoming, Lagarde called for re-capitalization of the European banking system, preferably by way of private refinancing, or - if necessary - by the forced injection of public funds.

Lagarde, as the former French minister of finance, should be aware of the true balance sheets of French banks, and so her comments appear particularly significant. For the first time, a major public figure has admitted the true underlying weaknesses in the euro banking system.

Later this month, the German parliament will meet in Berlin to approve a financial assistance package to Greece. This could be the beginning of the endgame in Europe.

If Germany refuses to pass the Greek bailout, the markets will panic, requiring massive emergency measures. This will inevitably involve countries with large financial surpluses, headed by China. Meanwhile one member of the euro system - Finland -backed by Austria, Slovenia and Slovakia, is demanding collateral in return for participation in the Greek loan package.

It's no coincidence that on Aug 25, the French president abruptly ended his trip to a far-flung French colony in the Southwest Pacific to fly to Beijing to meet President Hu Jintao.

President Nicolas Sarkozy announced his China visit as preparation for the G20 summit in November in Cannes. But a more immediate reason for the trip was to ensure continued Chinese financial support for troubled European borrowers, such as Greece, Portugal, Spain and Italy.

Sarkozy's visit was a reminder that the solution to the financial crisis, when it comes, will be a global one.

Even if Germany decides to support the Greek bailout, the time has come to address the fundamental issues involved in the Western financial crisis, namely excessive national and bank debt, uncompetitive Euro economies and undercapitalized Western banks.

The US economy remains the world's largest, by a big margin. The collapse of its housing market continues to undermine US consumer confidence and bank balance sheets, diminishing the prospects of a quick global economic recovery.

Key structural problems at the global level, which will take longer to address, include a monetary system based on the US dollar, which no longer provides financial stability, and an unbalanced world economy.

These are large issues that require a high degree of political determination and unification, the kind which was briefly seen immediately after October 2008, the beginning of the global financial crisis.

Unity dissipated as central banks flooded the financial system with cash, and disaster retreated.

But what we know now is that the monetary response of 2008 and 2009, while essential to restoring life to the system, was not a substitute for fundamental restructuring.

When Bernanke failed to announce another round of monetary injection also known as the third quantitative easing, or QE3 he acknowledged the limitations of central banks in addressing the underlying issues. Only ministers and politicians can do that. At the top of the list should be the restructuring and re-capitalization of Western banks.

Some of this has already happened in the US. But with the housing market's continued weakness, more needs to be done.

Warren Buffett's recent $5 billion (3.5 billion euros) investment in Bank of America is only a start. In Europe, the merger of two major Greek banks -Alphabank and Eurobank EFG - plus an injection from Qatar of 500 million euros into the restructured bank should be the precursor to other Euro bank restructurings.

Analysts at Credit Suisse recently estimated that 45 billion euros in capital is needed for the European banking system. Some of this capital is required to write off the massive amounts of bad loans that threaten the Western banking system.

The remainder is needed to increase the capacity of banks to withstand continued adverse economic conditions, and to allow resumed financing of industry and commerce, on which renewed economic growth depends.

In some cases, the restructuring of bank management will need to change. The fear of job losses at a senior level is keeping some banks from coming clean about their underlying balance sheet problems.

Today, the world's weakened financial state doesn't allow it the scope to respond as it did in 2008 to financially life-threatening events.

If the system crashes again, the possibility exists of major Western banks closing their doors, with large disruptions to trade and other industrial and commercial activity worldwide.

Britain's August riots provide a taste of the possible social consequences of a severe financial breakdown. Small, open economies that depend heavily on trade and capital flows would be particularly affected by a global economic upheaval.

The failure of the Greek rescue plan is one possible tipping-point; another could come later in the year when the European Central Bank finds itself unable to buy any more Italian and Spanish debt.

The author is visiting professor at the Guanghua School of Business, Peking University. The opinions expressed in the article do not necessarily reflect those of China Daily.