Tuesday, April 10, 2012

IMF urges authorities to adopt debt forgiveness to restore growth

A Telegraph article reports that the IMF is urging authorities to consider 'bold' actions to reduce household debt levels and get economic growth going again.

It is nice to have the IMF embrace one of the core elements of the Wall Street Rescues Main Street blueprint I proposed.

As your humble blogger has said on numerous occasions, the way Wall Street rescues Main Street is by absorbing the losses on the excesses in the financial system today.

Absorbing these losses means that the level of debt for both households and governments shrinks.  Which in turn frees up the scarce resources that were being used for de-leveraging to instead be used for economic growth.

High levels of household debt restrain consumer spending and delay recoveries, the Bretton Woods institution concluded in an analysis of crises over the past century.... 
the IMF said the authorities should consider going further with “targeted household debt reduction policies”.... 
Although the policies might initially be expensive, they would be beneficial by reinvigorating consumer spending and helping the economy, the IMF said.
By having the banks absorb the losses, the debt reduction policies are not expensive.
It cited the actions of the US in 1933 in the midst of the Great Depression and Iceland after its recent banking collapse. 
The Roosevelt administration in the US set up the Home Owners’ Loan Corporation to buy distressed mortgages from banks in exchange for government debt. It then restructured the mortgages “to make them more affordable”. 
The policy cost 8.4pc of GDP, equivalent to £130bn in the UK this year, but saved 800,000 households from repossession. The US government had made a profit, before inflation, by the time the scheme was run off in 1951. 
In Iceland, banks were made to accept reductions in mortgage interest payments of up to 40pc and the most distressed households had a portion of their outstanding debt written off. 
The economy there has now recovered remarkably since its bank-led collapse in 2008. 
The IMF said the lessons showed that “policies can help avert self-reinforcing cycles of household defaults, further house price declines, and additional contractions in output” and made a case “for government involvement to lower the cost of restructuring debt, facilitate the writing down of household debt, and help prevent foreclosures”....
It is remarkable just how well the Swedish model for handling a bank solvency led financial crisis works.
The IMF added that the banks need to be strongly recapitalised before debt forgiveness is considered, and that “bold” policies would be easier to implement in countries where there had been some state intervention in the banking system – as in Iceland....
Not a surprising recommendation given the failure of economists to understand the role of deposit guarantees and unlimited liquidity from the central bank in preventing runs on the banks after they have realized the losses.

Keep in mind three items when it comes to government guarantees.

First, when a child opens up a bank account and asks how do they know they are going to get their money back, no parent says it is because the bank has positive book capital levels.  They tell the child the government guarantees they will get their money back.

Second, almost nobody knows what the current level of book capital is for their bank (do you?).  At the same time, everyone knows that with their regulators' blessing, banks are hiding losses.  As a result, even if they knew the reported level of book capital, they don't trust it.

Third, everyone knows that the government extended the deposit guarantee to cover unsecured debt at the start of the financial crisis.  The annual stress tests are the government's way of renewing this guarantee.  It is hard to close a bank that passes the government stress test and inflict losses.
“These programs help prevent self-reinforcing cycles of declining house prices and lower aggregate demand. Such policies are particularly relevant for economies with limited scope for expansionary macroeconomic policies and in which the financial sector has already received government support,” the IMF said. 
However, loading all the burden on the banks and tearing up the law so households could walk away from their debts, as attempted in Colombia in 1997, would only trigger another credit crunch, it added.
Actually, without tearing up the law so households could walk away from their debts, but rather requiring the debts to be written down to levels the borrower can afford to pay has been done successfully in the US, Sweden and Iceland!

As shown by the US Savings & Loan crisis, financial institutions with negative book capital levels are fully capable of supporting significant quantities of new lending.  So there is no reason to be concerned with a credit crunch by loading all the burden on the banks.

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