Bank of England's Adam Posen: 'monetary policy alone not the answer'

The Telegraph reports that the Bank of England's Monetary Policy Committee member Adam Posen

said the eurozone’s undercapitalised banking system and not Greece is the real driver of the region’s woes.... eurozone governments must not be afraid to recapitalise and nationalise banks. 

“The biggest thing you need is forcefully injecting enough capital into the banking system,” he told a conference in Tokyo. 

“The source of current problems is not Greece ... The source of current problems in the eurozone is that various financial exposures we all have in the interbank market are not yet resolved because certain financial institutions are insufficiently capitalised, insufficiently disciplined,” he said.... 

There is a certain irony that Mr. Posen was speaking in Tokyo about the need for EU banks to hold more capital given the adoption by the EU and UK of the Japanese model for handling a bank solvency led financial crisis.  The focus of the Japanese model being to preserve bank book capital levels at all costs.

In days gone by, economists like Ben Bernanke lectured in Tokyo about how Japan needed to recognize the losses hidden on and off its banks' balance sheets and not preserve bank book capital levels if the economy were going to revive.

Regular readers know that in a modern banking system, bank book capital is there to absorb the losses on the excess debt in the financial system and protect the real economy from the damage that would occur if it were required to support this excess debt.

Mr Posen, who will leave the Bank when his term ends on August 31, said that while action taken by the European Central Bank to boost liquidity in the region’s troubled banking system had prevented a worsening of the crisis, monetary policy alone was not the answer. 

“Good monetary policy will not solve structural problems, bad monetary policy will make all structural problems insoluble ... Institutions require very active government intervention,” he said.

If the last five years have shown anything, they have shown that monetary policy is not the answer for addressing a bank solvency led financial crisis.

Taken to extremes, monetary policies like zero interest rates, quantitative easing and Operation Twist, destroy the capital markets as they intentionally undermine pricing and the assessment of risk in the bond markets and by extension (think Capital Asset Pricing Model), the stock markets.

Like Mr. Posen, your humble blogger has argued that the focus of policymakers should be on the banks.  Unlike Mr. Posen, I see bank capital for what it is:  an accounting construct.

For that reason, I support adoption of the Swedish model with ultra transparency to force the banks to absorb the losses on the excess debts in the financial system.  With these losses absorbed, extreme monetary policy measures will no longer be necessary.