Global financial crisis: it's the banks, stupid!

Following in the footsteps of the Bank of England's Mervyn King, a Guardian editorial looks at the ongoing financial crisis in Europe and concludes it is the banks.

Regular readers know we are dealing with a global bank solvency led financial crisis.

At the beginning of this crisis in 2008/2009, EU, UK and US policymakers and financial regulators chose the Japanese model for handling a bank solvency led financial crisis.  This model is based on pretending the banks have capital when they do not and praying for a miracle that will restore bank capital levels.

Naturally, a model based on lies and prayer has little chance for success.  History shows that it has never worked.  Japan has provided 2+ lost decades of proof.

At the beginning of this crisis and even today, policymakers and financial regulators could have chosen or could still choose the Swedish model for handling a bank solvency led financial crisis.  This model is based on requiring banks to recognize the losses on all the excess debt in the financial system today.  Subsequently, banks rebuild their book capital levels.

Naturally, a model based on curing the underlying problem has a long history of success in both the US (breaking the back of the Great Depression) and Europe (see Sweden).

So the question is, will the EU and Spain abandon the Japanese model and adopt the Swedish model?

Lined up in favor of adopting the Swedish model are the EU taxpayers and the real economy.

Society favors the Swedish model because it ends the drag on the real economy from the excess debt in the financial system.  As a result, the economy grows, jobs are created and governments do not adopt austerity policies that rewrite the social contract.

Lined up against adopting the Swedish model are the bankers.  They have a significant stake in the outcome of this decision.  Namely, if the Swedish model is adopted, their cash bonuses will be minimal for the foreseeable future.

Naturally, the bankers are claiming armageddon will occur if they are required to recognize their losses.  This is true for their bonuses, but not for banks supporting the real economy. 

In a modern financial system with deposit insurance and access to central bank funding, banks can continue to operate and make loans even while they have negative book capital levels.  Of course, while their bank capital levels are below regulatory requirements, banks have to retain all earnings and pay bonuses in stock while they rebuild their book capital levels.

This week, Spain's government did something extraordinary and dangerous – yet factually correct. Ministers admitted that their banks are in such severe trouble they'll require a bigger cash injection than Madrid can stump up....

An unnecessary injection of cash as Spain has a modern financial system.  Based on an IIF report, it will take 4 years for the banks to rebuild their book capital levels.

On the one hand, this is an extraordinary cry of desperation by a government that now freely admits it is all but locked out of financial markets, with lenders only willing to give it a loan at punitive interest rates. 

On the other, it is an admission of the truth – one that Spain, like so many other countries, has tried over the past couple of years to play down. 

But in finally admitting that its banking problem is too big for it to handle alone, Mariano Rajoy's government has thrown open the door to a whole bunch of concerns and questions: whether Spain will have to ask for what is commonly called a bailout (but is more accurately a giant loan) from the rest of the eurozone; whether the other governments in the single-currency club have the financial or political capital to extend that lifeline; and, crucially, whether all this can be done before the bank jog visible across the southern eurozone turns into a full-on bank run with Northern Rock-style queues outside the cajas of Andalucía. 

Before getting to those questions, though, it is worth saying this: at last, the leaders of the eurozone are talking about the issue that really matters – the existential threat to the single currency. Forget austerity, fiscal unions, and inflation regimes at the European Central Bank: with the large exception of Greece, the euro meltdown is primarily about how governments handle the wreckage in their financial sectors.

Four years of kicking the can down the road under the Japanese model and the wreckage in the financial sector is still there.

This is no surprise because the Japanese model does not get rid of the wreckage by anything other than a miracle.

Sure, other factors played a part – such as the vicious wage deflation in Germany that effectively priced southern Europe out of world markets – but the fundamental euro issue can best be summed up by twisting the old Clintonism: it's the banks, stupid. 

Not just insolvent banks in Spain or Ireland, either, but the bigger institutions that lent to them and throughout the go-go markets of peripheral euroland. Admit that, and you see how the mild austerity imposed in Spain is the wrong solution, especially when combined with the relaxed approach to restructuring its bust banking sector, encouraging them to admit to bad loans (with numbers that always looked suspect), to merge and to bring in old politicians as bosses. Just as in Ireland, the web of connections between the elite financiers and good-ol'-boy politicos helped fuel the boom and inevitably made sorting out the bust more complex, expensive and ultimately ineffective.

Please re-read the highlighted text as it summarizes why policymakers and financial regulators chose and continue to choose the Japanese model and why the Japanese model will not cure the underlying problem.

Admitting the root cause of the euro's problems does not guarantee a decent solution.

Admitting the root cause does get us one step closer to a decent solution:  the Swedish model.

There are two major issues here: one financial, the other political....

It is the political issue as represented by the web of connections between the elite financiers and good-ol'-boy politicos that prevents adoption of the Swedish model.