Sunday, July 29, 2012

The adverse link between sovereigns, banks and the real economy

One of the main themes of this blog has been the adverse link between sovereigns, banks and the real economy is the direct result of the policymakers' and financial regulators' choice of the Japanese model for handling a bank solvency led financial crisis.

Under the Japanese model, bank book capital levels are protected at all costs.  This has negative consequences for both the sovereign and the real economy.

In the case of the sovereign, it increases the debt at the sovereign as the state becomes the source of new capital to inject into the banks.

In the case of the real economy, it transfers the capital needed for supporting and growing the real economy to servicing the excess debt in the financial system.  At a minimum, this constrains growth in the real economy.  As the current financial crisis has shown, it puts the real economy into a downward spiral as capital that is needed to maintain the real economy is being transferred to debt service.

Of course, the downward spiral in the real economy feeds back negatively into the sovereign as it reduces tax revenues and the sovereign's ability to service its debts.  This in turn feeds back negatively into the real economy as the sovereign cuts its expenditures, including on social programs.  This is a self-reinforcing negative feedback loop that sacrifices society for the benefit of the bankers.

Protecting bank book capital levels at all costs has other negative consequences.  It crushes interbank lending as banks with deposits to lend still don't know who is solvent and who is not solvent.  It shatters the monetary transmission mechanism because protecting the zombie borrowers drives out loans to the creditworthy.

Regular readers know that your humble blogger champions the Swedish model for handling a bank solvency led financial crisis.

Under the Swedish model, banks protect the sovereign and the real economy.  Banks do this by recognizing all of the losses on the excesses in the financial system today.

Banks can protect the sovereign and the real economy because of the way that a modern banking system is designed.  Deposit guarantees and access to central bank funding mean that a bank can continue to function and support the real economy even if it has negative book capital levels.

As a result of the deposit guarantees, the taxpayers step up as 'silent' equity partners when the banks have negative book capital level.  Please note that as silent equity partners there is no need for an explicit bailout of the banks and a capital injection.

The choice to directly bailout the banks under the Japanese model was and still is driven by bankers wanting to protect their bonuses and policymakers and financial regulators agreeing to protect these bonuses.

The Swedish model was first used in the US by the FDR Administration to break the back of the Great Depression.  It has subsequently been used successfully in Sweden in the 1990s and by Iceland in the current financial crisis.

The Swedish model could still be used today to end the global financial crisis.

I have argued that the Swedish model should be adopted because protecting society (the real economy and the state) is far more valuable than banker cash bonuses.  This is an opinion that is not shared by the Financial-Academic-Regulatory Complex (FARC).

In the 1950s, President Eisenhower identified the military-industrial complex and said that it needed to be carefully watched and controlled less it bring great harm to society.

Unfortunately, nobody bothered to watch FARC.   As much as President Eisenhower feared the military-industrial complex, FARC has been much more damaging to society.

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