It is entirely another when Professor Ken Rogoff weighs in and confirms your humble blogger's diagnosis of a solvency crisis and the solution to this crisis. Professor Rogoff did this in a Financial Times column titled "the bullets yet to be fired to end the crisis'.
Four years into the financial crisis, it is becoming increasingly clear that the biggest deficit is not in credit, but credibility. Markets can adjust to a downgrade of global growth, but they cannot cope with a spiralling loss of confidence in leadership and a growing sense that policymakers are disconnected from reality.Regular readers of this blog know that this loss of confidence and growing sense of disconnect from reality are a direct result of the solutions that have been tried to end the crisis. All of the solutions have failed, but not without some unintended consequences like moral hazard.
What needs to be done to move away from the precipice?Understand that we are dealing with a solvency crisis and not a liquidity crisis.
At the root of today’s credibility deficit is ... policymakers count[ing] on rapid post-crisis recovery to help them avoid painful decisions on how to deal with badly overstretched private and public balance sheets, whether household debts in the US or sovereign debts in the periphery of Europe...
Every effort to delay a critical decision has ended unsatisfactorily.... further undermining the [policymakers'] credibility.The classic example of policymakers destroying their credibility is the European bank stress tests. When they were run last year, they gave a passing grade to banks in Ireland that were subsequently nationalized. When they were run this year, they gave a passing grade to banks in Spain and Italy. Within a month, these banks are under pressure as neither Spain or Italy can access the capital markets for sovereign debt without ECB intervention.
By far the main problem is a huge overhang of debt that creates headwinds to faster normalisation of post-crisis growth – that is why post-financial crisis growth is typically very slow. It is better to think of the global economy as going through a “Second Great Contraction” (the Great Depression being the first) involving credit and housing, and not just output and unemployment.It is not just the debt overhang that creates headwinds, but the fact that market participants know that a significant percentage of this debt is to borrowers who cannot repay. As a result, market participants want to know who is solvent and who is insolvent prior to investing as this has a direct relationship to the probability of the market participants getting their investment repaid.
Before market participants are going to invest their money, they want to know if it is going to fill the black hole of insolvency or invested in growing the business.
... Everyone agrees that bold action is required, but what kind of bold action?
... The most direct remedy, of course, would be to find expeditious approaches to cleaning up balance sheets whilst maintaining the integrity of the financial system.Disclosure of all the useful, relevant information in an appropriate, timely manner is the bold, expeditious approach. It is also the necessary and critical first step to addressing solvency.
With disclosure, market participants can know:
- Who is solvent and who is insolvent.
- Who is insolvent now, but has a business model that will allow them to recover over time;
- Who is insolvent now and needs an equity injection or a debt write-down to return to solvency; and
- Who is insolvent know and needs to be wound down.
If policymakers can at least get the diagnosis right, it would be a major step on the road to recovery. After a long series of half-steps and mis-steps, policymakers’ options are narrowing, but they are not out of bullets. Debt writedown schemes... can still substantially shorten the normally long window of slow post-financial crisis growth.
At this critical juncture, leaders must not only get off the sidelines, but must finally address the problems of a Great Contraction – not a large but otherwise conventional recession.