Telegraph's Jeremy Warner wrestles with what to do with 'zombie' borrowers

In his Telegraph column, Jeremy Warner looks at the pros and cons of helping 'zombie' borrowers.  In doing so, he lays out why the Swedish model for handling a bank solvency led financial crisis is superior to the Japanese model.

Housing and commercial property busts when preceded, as they nearly always are, by a big run-up in gross indebtedness, tend to be associated with much deeper slumps and weaker recoveries than ordinary recessions. 

China, and more recently Brazil, take note. What's just happened to the advanced economies may be about to afflict them, too....

Brazil and other emerging market economies with manifest property bubbles may be storing up a massive bust. 

We've already had ours, and nearly four years after the event the consequences are still there to behold, with an economy that remains 4pc smaller than its pre-crisis peak and the public finances in a state of abject ruin. 

A reflection of implementing policies to support the Japanese model of handling a bank solvency led financial crisis.

Plenty has already been done to ease the plight of those partially responsible, the imprudent and over-indebted household. 

Under the Japanese model, here is what has been done

To the entirely justified horror of savers, short-term interest rates have been slashed to zero and longer-term rates have been artificially depressed through quantitative easing. The benefits system has also subsidised incomes so that unemployed households can continue to service their debts. At the same time, banks have been bailed out, allowing a high degree of forbearance for financially overstretched households and commercial property owners.

Perversely, policy has bent over backwards to support those that least deserve it - the indebted profligate. Those who have borrowed more than they can afford have been bailed out as surely as the bankers. 

The intention was not to punish the virtuous, though such actions undoubtedly have, but to prevent an even more precipitous fall in consumption as households seek to adjust to more normal levels of leverage, and thereby forestall a self-feeding frenzy of repossessions, bankruptcies and collapsing demand.

An alternative was to write down the value of the debt in excess of the borrower's ability to repay.  This too would have forestalled a frenzy of repossessions, bankruptcies and collapsing demand.

I'm not going to argue that this was the wrong thing to have done, but my heart missed a beat on reading a pre-published chapter to the International Monetary Fund's forthcoming World Economic Outlook, suggesting that perhaps policy makers ought to go even further and engage in some form of debt forgiveness.

Actually, the IMF looked at Japan and realizes that the implementation of the Japanese model results in, among other bad outcomes, permanent shrinkage of the economy.

In my book, policy has already gone quite far enough in this direction. It would be wrong and patently unfair on those who, so to speak, stayed out of the dance, to do more.

True.  This is why the Swedish model for handling a bank solvency led financial crisis must be adopted and the Japanese model and its policies abandoned.

The case for going further rests largely on experience in the US during the Great Depression, and more recently in the US and Iceland during the current bust....

Unlike the Japanese model, the Swedish model for handling a bank solvency led financial crisis by requiring the banks to recognize the losses on the excess in the financial system today does have examples where it was successfully implemented.

What Iceland did was even neater. After the banking system collapsed, they simply rebased the principal to more affordable levels. The cost was largely born by foreign creditors in the collapsed banks. Iceland defaulted, but it allowed a clean start.... 

Despite the evidence that the Swedish model works and the Japanese model has not worked in either Japan or the UK, Mr. Warner chooses the Japanese model.  Apparently, he prefers the bad outcomes associated with the Japanese model.

In any case, there is no necessity for policy to go further than it already has. High levels of forbearance by the banks - which have allowed interest rate holidays and relatively generous re-mortgaging deals - has prevented the orgy of foreclosures seen in some advanced economies. As a result, the aggregate collapse in house prices hasn't been so bad – just 18pc since their pre-crisis peak, according to the Halifax index. 

Even this relatively modest approach to the challenge of excessive household debt has brought its own problems, helping to create what Fathom Consulting has termed a nation of "zombie households", or mortgage holders who can neither repay their loans nor bear any significant increase in interest rates. 

High levels of forbearance has allowed what are in effect bad debts to go unrecognised, starving the rest of the economy of much-needed credit and generally stifling productive recovery. The problem of an over-leveraged household sector has not so much been addressed as merely prolonged. 

If only we were Iceland, you might say, and could just start over. But we are not. The only reliable solution to our problems is time, and lots of it.

Japan has shown that under the Japanese model time is not a reliable solution.  Even lots and lots of time is not a reliable solution when policies do not address the problem, but merely prolong it.

Just look where the Japanese economy is after 2+ decades of pursuing the Japanese model.  GNP actually fell from 1995 to 2010.