Sunday, April 15, 2012

Have fiscal and monetary authorities run out of ammunition?

In his speech to the Institute for New Economic Thinking, the OECD's William White asked if fiscal and monetary authorities have run out of ammunition.  Specifically, the question is have they run out of room to continue to pursue the Japanese model for handling a bank solvency led financial crisis.

Recall that under this model bank book capital levels are protected and the real economy is asked to carry the excesses in the financial system.

Implementing the Japanese model requires adopting a series of policies ranging from suspension of mark-to-market accounting through regulatory forbearance through artificially low interest rates.  As Mr. White observes the problem with these policies is they create their own economic headwind (a point this blog has made several times previously).

While he did not mention it, Japan can be used as an example.  It has been pursuing these policies since its credit bubble burst in the late 1980s and its economy is at best stagnant and more often shrinking.

At the same time, the absolute level of its interest payments on its national debt continues to climb inexorably.  Japan is rapidly approaching the point where it does not collect enough tax revenue to cover these payments and the other expenses associated with supporting a modern society and has to borrow to make the interest payments.

When this occurs, does Japan run out of ammunition for continuing to pursue the policies under the Japanese model?

Given that the EU, UK and US adopted the Japanese model, Japan's experience should be of some interest because it provides some insight into what the end game for the Japanese model policies might be.

Furthermore according to Mr. White, a more important problem with these policies is that they do not address the private sector debt problem (again, a point this blog has made several times previously).

As he observed, these policies pretend that all of the private sector debt will be repaid even though it is clear that level of debt exceeds many borrowers ability to repay.  This inability to repay the debt combined with pretending that the debt can be repaid creates zombie companies, borrowers and banks.  Ultimately, the inability to repay the debt will have to be recognized and the debt restructured.

What will force this restructuring is that fiscal and monetary authorities run out of resources to use to postpone the restructuring.

The question is have the EU, UK and US governments run out of resources?

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