How the focus on bank capital levels endangered Medicare and how adopting Swedish model could save it

Professor Simon Johnson ran an interesting column in the NY Times in which he looked at the direct link between the bank solvency led financial crisis and ending Medicare.  Specifically,

The world’s largest banks have been accused of many things in recent years, including taking excessive risk in the run-up to 2008, doing great damage to the American economy by blowing themselves up and then working hard to resist any sensible notions of financial reform. 

All of this is true, but it misses what is likely to be the most profound negative impact of the banks’ behavior on most Americans. The banks’ actions led directly to an increase in government debt, which in turn has made the reduction of that debt by “cutting runaway spending” a centerpiece of the Republican presidential campaign to date. 

As a result of this pressure, Medicare now stands on the brink of being eliminated as a viable form of social insurance....

How is this possible? 

The economic mechanism through which a bank-led financial crisis has a broader adverse fiscal impact is straightforward. The recession that deepened sharply in 2008 implied a deep loss of tax revenue, mostly because people lost their jobs. Lower revenue means larger government deficits, particularly when the government also provides unemployment insurance, so spending also goes up.... 

This deficit implies a surge in government annual borrowing and in its stock of debt....

But the perception of a “fiscal crisis” brought the longer-run budget issues forward in time and the jump in government debt created a sense of panic in some quarters, so measures to “fix” the budget in a drastic fashion are now on the front burner in Washington. 

Ironically, although the main reason for the recent increase in public debt was the financial crisis, brought on by extreme deregulation, the situation has strengthened the hand of people who want, above all, to cut spending.

Medicare had been in the sights of conservatives for some time, but providing health care for Americans at age 65 is a very popular program, and with good reason. Before Medicare was created, it was very hard for people in their 70s, 80s and 90s to buy health insurance. If Medicare in its present form were ended, the adverse impact on older Americans with limited resources, including almost everyone who is not very wealthy, would be significant. 

Yet that is what those committed to reducing the size of government and its programs are prepared to do....

Part of the problem is that the Obama administration saved the failing big banks in 2009 and then defended them against being broken up in 2010 — the president’s top advisers consistently asserted that we needed highly leveraged and very large financial institutions, irrespective of the damage they cause....

The Obama administration continued the Japanese model for handling a bank solvency led financial crisis first adopted by the Bush administration.

Under the Japanese model, policies were adopted to protect bank book capital levels from the losses on the excesses in the financial system.  These policies included bailouts, low interest rates, suspension of mark-to-market accounting and regulatory forbearance.

Like Japan, the economy has not recovered as the policies end up distorting prices in both the financial markets and the real economy.

The alternative that could still be adopted and would save Medicare as we know it is the Swedish model for handling a bank solvency led financial crisis.

Under the Swedish model, banks would be required to recognize all the losses on the excesses in the financial system hidden on and off their balance sheets today.  Subsequently, they would rebuild their book capital levels through retained earnings.

The Swedish model was adopted by Iceland at the start of the financial crisis and their economy has recovered.

But while the precise mechanism differs across countries, the link from financial elite misbehavior to squeezing the lower half of society is present everywhere. In the United States, it most likely will take the form of ending Medicare in its present form.

To many people, the financial crisis of 2008 seems but a distant memory. If you kept your job or found another, you might feel that the adverse consequences are behind you. 

That would be a mistake. The worst is yet to come. When you are 85 and cannot afford decent health care, think about the banks.