Sunday, February 19, 2012

Does the Japanese model work for Greece, Portugal, Spain and Italy

[Please forgive the following.  I thought you might find it interesting as your humble blogger wrestles with  the implications of the Japan and Swedish models of dealing with a bank solvency crisis.]

As Iceland basks in the glow of returning to investment grade status in three years as a result of adopting the Swedish model for dealing with bank solvency, it raises the question of whether continuing to pursue the Japanese model will work for Greece, Portugal, Spain and Italy.

The Japanese model is built around recognizing losses on the excesses in the financial system only as quickly as banks are able to generate the earnings to absorb them (ie, meaningless bank book capital is preserved at all costs).

So the question is, can Greece, Portugal, Spain and Italy continue to delay loss recognition?

To answer this question, we have to look at those countries which have adopted the Japanese model - Japan, the US and the UK - and achieved a degree of financial stability.  How have they managed to achieve this degree of financial stability?

Each has a fiscal authority that issues unlimited quantities of debt that is purchased by both its captive central bank and its banking system.

This is a very important point.  There is no limit to how much debt these countries can issue because there is a captive market for the debt.  These countries' policy makers talk about capitalism, but when it comes to issuing debt they prefer a 'captive' market.

Please note, this is done at great cost to the real economy of these countries.  Look at where Japan's economy is now versus 15 years ago ... it has shrunk!

A shrinking real economy is not surprising because the central banks pursue a policy to minimize the cost of debt to the fiscal authorities.  A casualty of this interest rate policy is consumer demand, consumers save more to offset the lost earnings on their savings, and business investment, without growing demand for their products, business don't invest.

I made the point that these countries have achieved a degree of financial stability.  Rather than have a brief, but intense decline in the economy as the banks absorb the losses on the financial excesses as they would under the Swedish model, these countries have adopted the Japan model and locked in permanent long term decline.

How long is the long term?  Despite its aging population, I don't see any reason that Japan's economy cannot continue to gradually decline for the foreseeable future.

There is a degree of stability in this decline in that the government can prevent any precipitous economic decline because it can keep borrowing from the central bank and the banking system and keep spending.  An inconvenient fact that delays the investment returns for the hedge fund managers that are shorting Japan.

I can hear an objection already:  the economies in the US and UK are growing.  This too happened in Japan for the first few years after the credit bubble burst and zero interest rate policies were adopted.

The decline really set in as consumers and businesses came to realize that there is no easy exit from the Japan model.  If there were an easy exit, you would have thought the Japan would have done so.

Economists talk about growth in income as the solution to repay the debt taken on during the credit bubble.  Why did this not work for Japan as Japan was unable to tap into the significant global growth in income that occurred after its credit bubble burst and exit from the Japan model?

The problem that Greece, Portugal, Spain and Italy face is that while they have a fiscal authority and a banking system, they do not have a captive central bank.

As a result, it appears that they have a limited to how much sovereign debt they can issue.

Given that having unlimited ability to issue sovereign debt is a necessary condition for the Japan model to prevent losses from being recognized faster than the banking system can generate earnings, it appears these countries will have to abandon the Japan model sooner or later.

When they abandon the Japan model with its delayed recognition of losses, they will end up with the Swedish model and recognizing all the losses in the financial system today.  This promises to be ugly simply because the total size of the losses was increased by delaying their recognition.

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