IMF champions Swedish model for handling bank solvency led financial crisis

In the spring edition of its World Economic Outlook, the IMF championed the Swedish model for handling a bank solvency led financial crisis.  Specifically, according to a Guardian article, the IMF found that relieving debt holders of part of their debt speeds the recovery from a financial crisis.

The IMF's conclusion confirms what your humble blogger has said about why the Swedish model for handling a financial crisis (banks recognize losses today on financial excesses) results in a strong recovery and the Japanese model (banks recognize losses only to the extent that they generate earnings in excess of banker bonuses, dividends and de minimus capital retention) results in ongoing economic decline.

The IMF's conclusion also confirms the Wall Street Rescues Main Street blueprint for saving the financial system and protecting the real economy.

Governments should step in to help struggling households write off part of their mortgages in the wake of a financial crisis to avoid the risk of a prolonged economic slump, according to new research by the International Monetary Fund.  

In a chapter of the spring edition of its World Economic Outlook, the rest of which will be published next week, the IMF's economists find that a rapid buildup of household debt during a boom leads to a deeper downturn when the bubble bursts. 

"Housing busts preceded by larger run-ups in gross household debt are associated with deeper slumps, weaker recoveries, and more pronounced household deleveraging," they find. 

From Iceland to the US, Spain to the UK, a rapid increase in debt was a common characteristic across many economies in the years before 2007, as homeowners took advantage of low interest rates to borrow against the rocketing value of their properties. 

When house prices crashed, many borrowers inevitably found themselves in trouble and were forced to cut back sharply, contributing to the deep recessions that followed the financial crisis. 

But when they examined scores of historical property crashes, the IMF found that where consumers were battling with a heavy debt burden spending fell on average four times as fast as could be explained by the decline in house prices alone. 

"The decline in economic activity is too large to be simply a reflection of a greater fall in house prices. And it is not driven by the occurrence of banking crises alone," they say. "Rather, it is the combination of the house price decline and the pre-bust leverage that seems to explain the severity of the contraction." 

Because of this strong relationship between the debt burden before a crisis and consumer behaviour in the years afterwards, the IMF says governments should consider intervening to help households write off or restructure their mortgages.... 

In so doing, these programmes help prevent self-reinforcing cycles of declining house prices and lower aggregate demand."

The question is how should governments step in and facilitate this debt restructuring.

The answer under the Swedish model is rather than provide banks with regulatory forbearance, the regulators should force the recognition by banks of the losses on the excesses in the financial system.