Debts that can't be paid, won't be paid

Michael Hudson wrote an interesting paper that he delivered at the Institute for New Economic Thinking.  He observed that debts that can't be paid, won't be paid and therefore the question is who absorbs the losses.

Readers know that under the Swedish model, banks are suppose to absorb the losses by writing down the debt to reflect the borrowers true ability to repay the debt.

Banks are designed to spare the real economy from the economic headwinds created by these losses because the combination of deposit insurance and unlimited access to central bank funding allows them to continue operating even with negative book capital levels.

Mr. Hudson observes

A common denominator runs throughout recorded history: a rising proportion of debts cannot be paid. Adam Smith remarked that no government ever had repaid its debt, and today the same can be said of the overall volume of private-sector debt.... 

The great policy question therefore concerns just how the various types of debts won’t be paid. 

The choice is between forfeiting property to foreclosing creditors, or writing debts down at least to the ability to pay, and possibly all the way down to make a fresh start. Somebody must lose, and their loss will appear on the other side of the balance sheet as another party’s gain. 

Debtors lose when they have to forfeit their property or cut back other spending pay their debts. Creditors lose when the debts are written down or go bad....

Which is what would occur if the Swedish model were adopted.

He then discusses the burden put on the real economy by not requiring the banks to absorb the losses.

Writing down debts reduces the overall economy’s financial costs. Keeping debts on the books retains these costs. 

So when the financial sector (or the 1%) insists on maintaining the debts that have been run up – and supporting the debt-leveraged price of real estate pledged as collateral – securing its past “savings” gains are incompatible with maintaining a viable economy. 

The debt overhead becomes an expense that must be shed if the economy is not to shrink – and if it does shrink, more debts will go bad and a deteriorating spiral will set in.

Which is the experience of Japan, the EU, UK and US from adopting the Japanese model and protecting bank book capital levels.  By not having the banks absorb the losses, the losses have become overhead to the real economy.

Perception of this long-term macroeconomic dynamic is what has led the past few centuries of legal trends and political ideology to favor indebted labor and industry, and indebted governments as well. 

It explains why debtors’ prisons have been closed, and bankruptcy laws become increasingly humanitarian to enable debtors to make a fresh start. This idea of clean slates is only recently being extended to the economy-wide scale, starting with government debts to global creditors. 

Today’s financial trend threatens to reverse this pro-debtor reform tendency. Without acknowledging the economic and social consequences, the “business as usual” approach is a euphemism for sacrificing economies to creditors. It seeks to legitimize the disproportionate gains of banks and their rentier partners who have monopolized the past generation’s surplus. 

And it is to protect these accumulations that the FIRE sector has spent part of these gains to become the dominant voice in government, including the courts, as well as academia. 

Please re-read the highlighted text because it describes how difficult it will be to change course from the policies of the Bush and Obama administration.

The aim in practice is to impose austerity and economic shrinkage on the private sector, while the public sector sells off its assets in a voluntary pre-bankruptcy. 

The internal contradiction in this policy is that austerity makes the debts even harder to pay. A shrinking economy yields less tax revenue and has less ability to create a surplus out of which to pay creditors. Debt repayment is not available for spending on current goods and services. 

So markets shrink more. 

This is not an inevitable scenario. Governments are sovereign with regard to their creditors. They still posses the alternative power to wipe out the debts – along with the savings that are their counterpart on the opposite side of the balance sheet. .... But it calls for creditors to take a loss.

Of course, the voters could simply impose the Swedish model if there were candidates who were willing to adopt it.

Recent history shows that this is unlikely as one of the major sources of campaign donations is the industry that would like to prevent having to be required to recognize the losses.

This has happened again and again in history for the past five thousand years. Until recently it was the normal result of financial crashes – the final stage of the business cycle, so to speak.

Even the US has experience with the Swedish model as it was used by the FDR administration to break the back of the Great Depression.

But as economies have been financialized, creditors have gained political power – and also the power to disable realistic academic discussion of the debt problem. What they fear most of all are thoughts of how to avoid today’s arrangements that have given them a free lunch at the rest of the economy’s expense.