Troika diktat looms large in reason for credit crunch

In his Irish Times column, John McManus describes how the current approach to handling a bank solvency led financial crisis has lead to a credit crunch.

Regular readers know that policymakers and financial regulators are pursuing the Japanese model under which bank book capital levels are protected at all costs.  It is the protection of these capital levels that leads directly to the credit crunch and damage to the real economy.

The alternative way to handle a bank solvency led financial crisis is to pursue the Swedish model under which banks recognize and absorb all the losses on the excess debt in the financial system today.  This model protects the real economy.

ANONYMOUS LETTERS are usually best ignored, but one which awaited me on my return from holidays was hard to ignore, not least because of the following opening line: “I am writing this letter in a state of extreme anger, this very week I have seen my brother go out of business or to be more clear he was put out of business by his bank.” 

The letter writer went on to encapsulate the chronic problem with credit for business and also the debate about the wider costs of the approach being adopted to fix the economy. 

It is intuitively obvious to everyone that protecting bank book capital is wrong.  What is important to protect is the real economy.

That is why a modern banking system is designed to support the Swedish model for handling a bank solvency led financial crisis.

Specifically, banks have deposit guarantees and access to central bank funding.  These allow a bank to absorb all the losses on the excess debt and continue operating for years supporting the real economy even if the result of absorbing the losses is negative book capital levels.

The brother in question had been in business for more than 20 years and had expanded before the recession at a time when credit was easily available from the banks. 

His business was struggling, but all 17 employees and creditors were being paid. The owner was not drawing a wage and had sold his home in 2010 to release some equity for his business. According to his sibling he had regular reviews with the bank and they had agreed to accept interest-only payments. 

“Up until now he was compliant with all their demands. Then all of sudden they re-called his loans which they knew well he would not be able to pay. He is a broken man. He always had such high regard for employees’ welfare, now we have 17 new people on the live register, 10 of whom have mortgages.” 

It is a far from unique story, but the writer did a good job of capturing the sense of unfairness and bafflement most people experience when confronted which such a story. 

“Will someone please tell me where is the sense of justice in this and how they are able to get away with it? Who the hell is sanctioning this behaviour? We bailed out the banks and this is how they are treating hard- working people. Of course my brother is not unique. He is the third business that I know for a fact this has happened to . . . ”

The letter-writer asks a lot of questions, but they all seem to boil down to one: why is the Government allowing this seemingly counterproductive and wrong-headed behaviour to continue?

Your humble blogger would say that it is the direct result of adopting the Japanese model and bailing out the banks when they are designed not to need a bailout.

It’s quite an easy question to answer. An economic crash as widespread and severe as the one that has engulfed Ireland does not lend itself to the sort of overarching solution or co-ordinated policies that would, as the writer seems to suggest, maximise the number of jobs retained in the economy.

Actually, Iceland showed that by adopting the Swedish model, precisely this outcome was easily obtainable.

It’s not that it’s not a good idea, it is just that it is beyond the capacity of our Government, or probably any government. 

It is only beyond the capacity of governments who are captured by or, and this is effectively the same thing, take advice from current or former bankers.

Everywhere that governments have listened to the bankers, there have been bailouts.  Everywhere that governments have listened to the bankers, there are ongoing problems in the financial system and the real economy is struggling (note:  it took some time, but the problems with the real economy have now hit Germany too).

Remarkably, the one country that did not listen to its bankers and bail them out was Iceland.  Iceland's economy is growing and the financial crisis is behind it.

The approach that has been adopted, at the behest of the EU-IMF-ECB troika, has been to focus on sorting out the Government finances by cutting spending and increasing taxes, even if this is counterproductive in the short term because it hits growth.

Japan has shown that this has been counterproductive for 2+ decades.  By most people's standards, this sorting out the government finances is counterproductive in both the short and long term.

Banking is another area and the focus here is to return the banks to solvency and profitability which will in theory allow them resume lending normally to business.

This is the argument that bankers use as justification for bailouts and to continue receiving their bonuses.

It is based on the assumption that lending and bank solvency are linked.  This assumption is false.

Lending and how the loans are financed are separate.  The reason they are separate is that the bank does not have to hold on its balance sheet the loans it originates.  There are any number of market participants who could hold the loan including other banks, insurance companies, pension funds, mutual funds and hedge funds.

Part of this process involves the banks biting the bullet on non-performing loans. The short-term consequences of this – such as the decision to pull the plug on the letter-writer’s brother’s business and the 17 jobs that will cost – are judged a price worth paying for solvent banks.

Part of banks biting the bullet on non-performing loans under the Swedish model is that the loans are modified to a level that is consistent with the borrower's capacity to repay.  The only limit on this is if someone else is willing to offer more for the collateral supporting the loan than the value of the borrower's repayment stream.

Please note, bank solvency is independent of whether the bank pulls the plug on non-performing loans. Bank solvency is determined by comparing the market value of the bank's assets to the book value of its liabilities.  If the market value of the assets is greater, then the bank is solvent.  If the market value of the assets is less, then the bank is insolvent.

Pulling the plug on this loan did not change the solvency of the bank.  All it did was hurt the Irish economy.

However, this doesn’t really go anywhere near answering what seems to me to be the deeper issue raised by the letter-writer which is why and how we have decided to go down this particular policy path with its calamitous social consequences. 

Or as he puts it: “This is achieving nothing but destruction. Are the government thick, blind or just don’t give a damn? People need to know what is happening. The bank are not paying for this, the taxpayer is.”

The writer is in good company when it comes to questioning the economic arguments for the current policy prescription.....

It is also common case that the approach adopted in Ireland has never been applied to a developed democratic economy. 

It is a mix of IMF policies forged in less developed countries overlaid by an unforgiving type of economic thinking typified by the ordoliberalism that has taken hold in Germany. 

But as long as Ireland remains in a bailout, we have little choice but to follow the path prescribed by the troika when it comes to the banks.

Ireland always has the choice of adopting the Swedish model and forcing its creditors to absorb losses.

So to try and answer the writer’s questions more fully: the Government probably does know what the banks are doing. But whether they approve or not is arguably irrelevant as long as Ireland remains in a bailout as we have little choice but to follow the path prescribed by the troika. 

Whether they have any better ideas or could implement them is a moot point. I am not sure this helps.

It is incredibly important that there is a better alternative and that this better alternative could be implemented.  It is not a moot point.

Every day that passes and the Irish government does not adopt the better alternative is another day that the Irish government has elected to put the interest of bankers ahead of the interest of the Irish citizens.

Will creditors be mad that they are made to absorb losses?  Yes.

Will creditors get over it?  As shown by Iceland, yes.