Japan admits that its model for handling a bank solvency led financial crisis doesn't work

In his Telegraph column, Thomas Pascoe discusses how Japan is admitting after 2+ decades that its model for handling a bank solvency led financial crisis doesn't work.

The implications of this admission are huge for the EU, UK and US which have been implementing this model (what your humble blogger refers to as the 'Japanese model') for handling their own bank solvency led financial crises.

Japan is saying that their policy approach does not work.

What policy approach is this?

The policy approach that says that bank book capital levels must be protected at all costs.  This protection leads to the adoption of policies like bailouts, regulatory forbearance that lets banks create 'zombie' companies by engaging in 'extend and pretend' when it comes to loans, zero interest rates and quantitative easing.

Under the Japanese model, banker bonuses and bank book capital levels look great.  Unfortunately, this transfers the burden of the excess debt in the financial system onto the real economy.  A burden that deprives the real economy of the capital it needs to reinvest to maintain and grow.  This capital is instead diverted to repay the excess debt.

The Swedish model is the only policy approach for handling a bank solvency led financial crisis that has been proven to work.  It worked in the US to break the back of the Great Depression.  It worked in Sweden in the 1990s.  It worked in Iceland for the current financial crisis.

What policy approach is this?

The policy approach that says that banks must absorb the losses on the excess debt in the financial system today.  Subsequently, the banks can rebuild their book capital levels.

Under the Swedish model, society and the real economy look great as the burden of the excess debt is absorbed by the banking system.  As a result, bank book capital levels look bad and banker bonuses look even worse.  Which is how it should be given that bankers should be held responsible for not making loans that the borrowers cannot repay.

A win/win for society and the real economy.

What is newsworthy is that, having tried and failed with every other option, the Japanese government may be taking a remarkably novel approach. It appears as though they are going to try to spend close to what they receive in taxation.... 

This is a turnaround for Japan. The nation’s government has already contorted itself in all the ways now common in the West while attempting to postpone this day. This, after all, is a country whose own central bank rebuked itself last month for breaking its own rule and buying more bonds than there is currency in issue. 

As in the West, the Japanese have stuck to the dogma of easy monetary policy to fight decline, and as in the West it has not worked. The Japanese instituted Quantitative Easing a decade ago and found that it has done little to fight deflation and nothing to avert stagnation. 

Interest rates close to zero did work for a while, but not in the manner imagined. Now that Japan is not unique in having a low interest rate, the correction has been harsh.... 

The manufacturing industry has been hit hard as US and German manufacturers have picked up market share. Factory jobs are at their lowest ebb since records began in 1953, while Japanese manufacturers will make 39pc of their products abroad this year, another record. 

Bloomberg has reported that one Japanese study envisages four million jobs being lost as Japanese manufacturers relocate production in the next decade. The impact of the currency on this cannot be overstated – Goldman Sachs has estimated that, for every one yen appreciation against the dollar, Toyota loses 3.3pc of its revenues. 

Even so, Japan is in a better position than similar Western economies. For a start it has (or had at year end 2011) the best net asset position in the world, where assets held abroad are concerned. 

Net assets owned abroad by the Japanese central bank and private investors amounted to 54pc of GDP at the start of the year. In contrast, Britain had a net global liability of 13pc of GDP. The Japanese have liquid assets abroad which they can monetise and repatriate to mitigate any meaningful austerity programme, something our government lacks..... 

However, Japan’s horizons have been blighted by cloud for much of the past two decades.

A cloud caused by not having the banks recognize the losses on the excess debt in the financial system at the beginning of its bank solvency led financial crisis.

By adopting the policies it did, Japan let the banks postpone recognizing these losses.  The result was zombie companies and zombie loans.  These zombie companies create a cloud in the real economy.