Baupost's Seth Klarman explains why pursuing Japanese Model is wrong

In his Q3 2012 letter to investors (hat tip Zero Hedge), Baupost's Seth Klarman goes through the various policies initiated under the Japanese Model for handling a bank solvency led financial crisis and explains why these policies are bad for the real economy in both the short and long run.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  This drives the burden of servicing the excess debt onto the real economy.  In turn, this cause the real economy to shrink.  This in turn is responded to with fiscal and monetary stimulus (like zero interest rates and quantitative easing).

However, embedded in the fiscal and monetary stimulus are headwinds to further economic growth.  As a result, pursuing the Japanese Model effectively condemns the real economy to a Japanese-style slump.

Regular readers are familiar with Mr. Klarman's argument as it repeats many of the same points your humble blogger has made.

Perhaps the oddest part of the ongoing QE scheme is that everyone can see in its fullness and boldness the attempted manipulation of Americans' behavior. (If people know they are being manipulated, do they behave exactly the same as if they don't know?) 

While anyone would be glad to have a cheaper mortgage as a result of QE3, would they really believe this would make their home worth more?  

It's more of a credit holiday, whereby the government offers you better terms than previously available. ... 

Also, artificially low interest rates have a cost to the government. 

As we know from the recent U.S. housing price collapse, mortgage lenders can indeed lose money. The guarantor of the U.S. housing market has a huge contingent liability. Moreover, the U. S. housing market was clearly overbuilt (by five million homes, according to some estimates) as of 2007, yet cheap financing may attract temporary incremental demand which home-builders might interpret to be permanent and thus overbuild all over again.  

This highlights the deleterious second and third order effects of well-intended but ill-conceived government programs. 

It is clear that someday the Fed will decide that the economy has strengthened sufficiently to end and then potentially reverse QE and zero-rate policies. Any possible sale of trillions of dollars of securities owned by the Fed, at such time would most likely be at a substantial loss given that interest rates would likely have risen and bond prices have fallen. 

Also, when people with a 30 year, 3.5% mortgage seek to move at a time when new mortgages now cost 5% to 6% or more, buyers will pause, reducing demand and driving house prices lower.  

QE3 may deliver a dose of helium to housing prices, but eventually helium leaks out of balloons, and gravity pulls them to earth.  

What kind of policy is this: untested; inflationary; eroding free market signals; diverting more of the country's resources toward housing at the expense of priorities such as infrastructure, technology, or science and medical research; and inevitably only a temporary fix with no enduring benefit?

Please re-read Mr. Klarman's question as it highlights just how destructive pursuing the Japanese Model and its related policies is to the real economy.

Finally, we must question the morality of Fed programs that trick people (as if they were Pavlov's dogs) into behaviors that are adverse to their own long-term best interest.  

What kind of government entity cajoles savers to spend, when years of under-saving and overspending have left the consumer in terrible shape? What kind of entity tricks its citizens into paying higher and higher prices to buy stocks? What kind of entity drives the return on retirees' savings to zero for seven years (2008-2015 and counting) in order to rescue poorly managed banks? Not the kind that should play this large a role in the economy.

Please re-read the highlight text as Mr. Klarman has made a clear case for adopting the Swedish Model with ultra transparency and making the banks absorb the losses on the excess debt in the financial system.

One of the benefits of adopting the Swedish Model is it eliminates the need for destructive policies.

Recently, a financial columnist wrote: "Four years after the fall of Lehman Brothers, and with-a presidential campaign in full swing, everyone can surely agree on one thing: we shouldn't risk another financial crisis." 

While I'm sure he is well-intentioned in this sentiment, this highlights a flawed notion held by too many of our country's commentators and regulators. What does it even mean to risk or not risk a financial crisis? You don't intentionally risk financial crises; they just happen. In fact, there is no way to not "risk them". And they don't usually provide fair warning. 

Financial crises are awful: they affect the lives of individuals and families; they can damage the economy, weakening it to the point of tearing the social fabric they often take years to overcome. It would be great if we could outlaw them, but unfortunately we cannot. 

Ironically, attempts to limit short-term pain, such as those in the four years did counting since the collapse of 2008, almost certainly make a future crisis much more, not less, likely. 

The seeds for financial crises typically grow undetected from a variety of excessive behaviors and assumptions, to where they become almost inevitable. 

Financial crises are rooted in over leverage and excessive levels of valuation. If society wants to prevent crisis, it must take measures well in advance, before the storm clouds gather, before excesses build in the system and before unbridled optimism dominates investor and business thinking. 

Efforts to constrain incipient crises in order to avoid feeling their full wrath, such as propping up bankrupt institutions and bankrupt countries, merely result in stagnation and a protracted period of subdued economic activity. 

Proper regulation might make some difference, if it had the effect of limiting leverage and containing speculative bubbles; but so much of regulation is naïve, ill-considered, and poorly enforced, thereby rendering it ineffective.

As Mr. Klarman points out, relying on regulation and regulatory oversight does not make the financial system stable.

Anyone who believes that government control and intervention will prevent problems of all sorts is living in a fantasy world where what we wish will happen always does. 

Go back to 2007 where the world was seemingly in a perpetual period of prosperity with low volatility while stock markets were hitting record highs. Few sniffed the possibility of any crisis on the horizon. Virtually no one imagined the magnitude of the crisis that erupted only one year later.  

Financial crises, sadly, will be with us forever. The idea that we can avoid one at our will only suggests both a dangerous naivete regarding how the world works and also the likelihood that when a crisis does arise, years of built up excesses will ensure that it will be far worse than it would otherwise have been. 

An environment where financial crises are seen to be a regular part of the landscape is one where people might actually take more precautions.  

People would maintain a margin of safety in all their decisions. investment and otherwise, regulations would be well thought out and diligently enforced, and the unscrupulous and the incompetent would quickly fail and disappear from the scene.

The bedrock for the market that Mr. Klarman discusses is transparency.  It is only with all the useful information in an appropriate, timely manner that investors can independently assess the risk and build a margin of safety into their decisions.

This is why I have argued for bringing transparency to all the opaque, corners of the financial system.

Modern day attempts to abolish failure only serve to ensure it, as moral hazard-- the likelihood that people's behavior changes in response to artificial supports or guarantees-- surges. Attempts to prevent or wish away future crises only make them more likely. Only by allowing, even welcoming, episodic failure do we have a chance of reducing the likelihood and magnitude' of future financial crises.