Europe’s biggest economy is well on its way to making a key mistake blamed for Japan’s “lost decade” of economic stagnation in the 1990s by failing to clean up its banks decisively. The obstacles are political rather than financial. Berlin seems determined to avoid telling voters the bad news before a September 27, 2009 general election about banks’ expected losses and the likely cost to the taxpayer.

Instead, the government is allowing banks to conceal or defer the full extent of losses on toxic securities and bad loans, and refusing to subject them to public stress tests or to force them to increase their capital. In doing so it risks perpetuating “zombie banks” that are too sick to lend to businesses and households.

“There are very strong political reasons for the policy paralysis,” says Nicolas Veron of the Bruegel economic think-tank in Brussels. “Nothing can happen before the German election. But Japan waited a decade. We can wait three months.” It is no surprise that when the European Central Bank flooded Eurozone banks with €442bn in liquidity last month, most preferred to deposit the money back with the ECB overnight or put it in safe government bonds rather than lending to the real economy.

Despite jawboning from ECB president Jean-Claude Trichet and threats by German Finance Minister Peer Steinbrueck, the banks are effectively on lending strike because their problem is not liquidity but solvency. Anxious to avoid a credit crunch before the election, Steinbrueck recently failed to convince his European Union peers to suspend bank capital adequacy rules pending reforms that are due later this year. He was also rebuffed by the Bundesbank when he appeared to endorse the idea of the German central bank lending directly to businesses to bypass a frozen capital market.

Banks are expecting more loans to go sour and heavier losses on impaired assets as the recession bites deeper, eating into their capital base. Their instinct is to draw in their horns and reduce leverage, which got them into the mess in the first place. The ECB’s latest Financial Stability Review explains why. It estimates that Eurozone banks face a further $283bn in write-downs by the end of 2010 on top of the $366bn in losses written off since the crisis began in mid-2007. Rather than forcing banks to recognise those bad assets and remove them from their balance sheets, most Eurozone governments have been playing for time, seemingly hoping that something will turn up.

Close links between Germany’s banks and its political establishment are another reason for reluctance to carry out painful restructuring. The regional Landesbanks and savings banks are key levers of political patronage. In an earlier role as state premier of North Rhine-Westphalia, Steinbrueck was a negotiator with the European Commission on behalf of WestLB and other state-controlled Landesbanks. Of the private sector banks, Commerzbank is on government life support.

Germany’s bad bank scheme for commercial and state banks is designed to stretch out the problem over the next two decades rather than resolve it. Banks may voluntarily put toxic assets into special purpose vehicles guaranteed by the state until maturity, paying an annual fee. But if the assets are worth less at the end than the price assessed by an independent valuer, the liability rests with the banks, not the taxpayer.

Italy, France, the Netherlands, Belgium and to a lesser extent Spain are all in denial about the extent of their banking problems, although the Dutch, Belgians and French have had to spend billions of euros of taxpayers’ money to save Fortis, ABN Amro, ING and Dexia SA. Spain has been bolder, creating a €9bn bank rescue fund, expected to lead to a wave of restructuring, tie-ups and bail-outs after the country’s housing bubble burst.

So what does the Eurozone have to do to avoid a Japanese-style prolonged period of stagnation with zombie banks? Governments should start by telling voters and markets the truth about their banks’ exposures. Far from undermining confidence in all banks, as Steinbrueck contends, disclosure would restore trust in sound institutions and dispel general suspicion. They should then compel banks that are found wanting to increase their equity capital, either from private investors if they can, or from the state if they must. This may lead to a temporary nationalisation of some sick banks, as Britain did with Royal Bank of Scotland. Ultimately, banks that are not viable must be broken up or closed down.

The European Commission’s competition department and the Committee of European Banking Supervisors can provide pan-European political cover for governments that fear taxpayers’ wrath at bailing out banks with public money. The way should be clear once Germany has voted. It would be dangerous to delay any longer. As the Japanese example shows, procrastination merely increases the long-term pain.