Until now, policymakers could always pull a new rabbit from their hat to try to buy time in the face of the solvency crisis. These efforts included bailing out financial institutions with direct equity investments, providing trillions of dollars of liquidity through zero interest rate policies, QE1, QE2, and purchase of securities; regulatory forbearance through suspension of mark-to-market accounting and adoption of extend and pretend for loan valuations; and fiscal stimulus. All have been tried. All have succeeded at buying time. All have not prevented the re-emergence of the solvency crisis.
As this blog has repeatedly said, the only way to address the solvency crisis is through disclosure. It is only when market participants have all the useful, relevant information in an appropriate, timely manner that they can determine who is solvent and who is not solvent. More importantly, it is only when this determination has been made that it is possible to select a path forward.
The word economics comes from the Greek word for household management. Let us then draw a distinction between the real world of households, in which people work, consume, invest, save and borrow, and the artificial economic universe created by politicians and bankers....
When the banking crisis broke, everyone seemed to agree on the first vital task: an audit. The liabilities should be identified. Where necessary, the banks should be recapitalised.
Once the central banks were seen to stand behind the banking system, there would be no more queues round the block while depositors sought to rescue their money. Calm would return and with it, bank lending at sensible levels.
This has not happened. It seems we are no nearer to identifying the toxic assets than we were at the beginning. Phase two of the banking crisis could be upon us at any moment. But even if it is too late to avert chaos, the toxicity must be tackled.
Under central bank supervision, it may then be possible to segregate the overpriced assets in a so-called bad bank, so that they can be gradually written down and returned to the market at a realistic valuation.
The central banks should also ensure that the banking system has enough liquidity ... Although there is a moral hazard in saving banks from the consequences of financial misjudgment, they were not alone in their illusions ... But it would help to placate the public if the costs of rescuing the banks fell as heavily as possible on the banks' senior officials, as well as on shareholders and bond-holders.