Why are the markets happy?

Stock markets the world over surged after the US Treasury announced its latest plan. The Dow jumped almost 500 points, its biggest one-day point gain since November 21. What makes this plan so different, and why are the markets so happy?

One of the key learning from the Japanese lost decade was that 'Zombie Banks' prolonged the crisis. Towards the end of the last century, the Japanese real-estate and stock market bubble burst. The country was faced with a situation which is similar to what the US economy is facing right now. It had a lot of banks had made huge loans, and the loans were going sour pretty fast (as customers and businesses failed to make monthly repayments). One of the biggest mistakes that Japan made was that it helped these banks survive.

The banks had so much bad loans on their book that their total liabilities exceeded their assets. Thus they were very reluctant to make more loans. As banks reduced making newer loans, other industries became starved of cash to run their business and people could not finance their big-ticket purchases. This caused massive problems within the economy.

In any economy, the only way governments can give money to the businesses and consumers is though banks. Hence the Japanese government reacted by giving more money to the banks (hoping that the banks would lend it to businesses and consumers). The banks, on their part, were very happy to take the money and keep it with themselves - to improve their reserves (i.e., make sure they have enough money - in case more loans go bad)!

These banks came to be known as 'Zombie Banks'. They were practically insolvent and the Japanese government fed them money to keep them 'alive'. However these banks just hoarded up the money and did not plough it into the economy. This ended up prolonging the crisis for many more years.

In the US, there were fears of banks like Citibank and Bank of America becoming 'Zombie Banks'. The fears were primarily because these banks have huge portfolio of bad loans. They are also hoarding up government money and not lending out as much as they should. The situation is very similar to that in Japan few years ago.

Hence, the announcement by the Treasury is very important. The announcement basically says that the bad loans that these banks have will be bought over by the Treasury. Once banks become free of their bad loans, they will again start lending out to businesses and consumers. This will help get the economy moving again. Consumers will be able to buy more goods, factories will increases production, and more people will get jobs.

But as with any other plan, implementation will be the key. If the Treasury is successful in implementing this plan, it will have effectively averted one of the biggest mistakes that led to the Japanese lost decade.