Sunday, May 6, 2012

How to restore growth to Europe

Now that the voters have rejected austerity and protecting bank book capital levels, the question is how to restore growth in Europe.

The key is to make use of the unlimited amount of capital that banks can provide to protect the real economy.  For example, banks can absorb the losses on the excess in the financial system and reduce the outstanding debt to what the borrowers can afford to pay.  This applies whether it is sovereign debt or consumer debt.

This is critical as it eliminates the distortion in asset prices currently going on as a result of regulatory policies like 'extend and pretend'.

This is critical because it supports the internal devaluation that is needed to make countries like France and Spain cost competitive with Germany.

This is critical because it quickly brings to an end the downward pressures on the real economy from the housing bust and sets the stage for economic expansion.

Clearly this will result in banks with significant negative book capital positions.  However, as discussed previously, this is not problematic for a modern banking system where deposits are guaranteed and the banks have access to central bank funding.  The banks can continue to operate while they rebuild their book capital levels and support the real economy with loans.

Using bank capital to set the stage for growth, it is up to the governments to adopt fiscal policies to jumpstart growth.

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