Monday, February 13, 2012

Its still not to late to adopt the Swedish model and stop the financial crisis

The time has come to finally stop the financial crisis.

Clearly the policies that have been pursued since the financial crisis began on August 9, 2007 have not stopped the crisis, but rather have seen the crisis morph from a bank "solvency" crisis to a sovereign debt and bank solvency crisis to a government, sovereign debt and bank solvency crisis.

Today, Greece represents what happens when the financial crisis is not stopped.  Rather than have the global banking system absorb the losses on debt that Greece will never be able to repay, policymakers have thrown out a democratically elected government and installed technocrats who have chosen to force the losses into the real economy and as a consequence Greece into an economic depression.

The last time this occurred under similar circumstances, Germany was trying to pay reparations for World War I.  It is ironic that it is Germany leading the charge to have Greece suffer a depression rather than write-down the loans.

If Greece suffering a depression ended the financial crisis, then perhaps this policy could be accepted.

However, this policy does nothing to halt the ongoing financial crisis as there is significantly more debt outstanding globally than the borrowers can afford to pay.  Until this fact is addressed, the financial crisis will continue.

Over the last several posts, I have focused on the simple fact that policymakers have to make a choice everyday in how they address the financial crisis.

Every day, they have to choose between continuing with the failed Japanese model (only absorb losses as quickly as the banking system generates earnings) or adopting the Swedish model (banks absorb losses today).

Every day during the Greek crisis, policymakers have chosen the failed Japanese model despite the obvious damage to Greek society (it does raise an interesting question:  are banker bonuses really more important than a peaceful, productive Greece).

So what is the Swedish model for stopping a financial crisis?

As described in an article in the NY Times,

The country was so far in the hole in 1992 — after years of imprudent regulation, short-sighted economic policy and the end of its property boom — that its banking system was, for all practical purposes, insolvent. 
But Sweden took a different course than the one now being proposed by the United States Treasury....
The failed Japanese model.
Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government. 
That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.... 
Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years.
According to a Time magazine article, Sweden did more than this:
The government issued blanket insurance for a period of four years to creditors in all the country's 114 banks. 
Finally, according to Occasional Paper 79 by the Group of Thirty (otherwise known as Lessons Learned from Previous Banking Crisis:  Sweden, Japan, Spain and Mexico), Sweden combined all of the above with transparency.

Both the banks and the authorities had to disclose the extent of the problems and the methods for solving them in some detail and based on realistic, even conservative, assessments.

In summary, the Swedish model has three main elements besides that any funds invested by the government should receive a return that reflects the true risk being taken on:

  1. Banks write-down their bad on and off-balance sheet exposures today and rebuild book capital through retention of future earnings and equity issuance.
  2. Governments guarantee both depositors and unsecured debt holders for several years while the banks rebuild their book capital.
  3. Banks provide transparency.

Regular readers will immediately recognize that the Wall Street rescues Main Street Blueprint proposed by your humble blogger contains these three elements of the Swedish model.  But that is not surprising as the first time the Swedish model for ending a financial crisis was successfully implemented was by FDR in the 1930s.

The Wall Street rescues Main Street Blueprint is a version of the Swedish model that uses 21st century information technology to provide transparency.

The Blueprint not only stops today's financial crisis, but it facilitates the adoption of the FDR Framework and the prevention of future financial crises.


Anonymous said...

"It extracted pounds of flesh from bank shareholders before writing checks."

Yes, but IIRC it didn't do any bondholder haircuts, which was a major failing IMHO.

Wells Fargo Must Die said...


Eric L. Prentis said...

The bankrupt financial system should be nationalized, a la the Swedish method. Many excellent solutions for consideration are available, e.g., the Swedish financial crisis solution , Mr. Bill King’s parallel banking system , Mr. William M. Isaac’s FDIC assisted merger approach or James Gailbraith’s idea of extending the existing system are excellent examples.