Tuesday, October 16, 2012

Sorry, it is economic recoveries from systemic financial crisis that don't use the Swedish Model that really aren't different

In their recent update This Time its Different, Again? and their Bloomberg column, Carmen Reinhart and Kenneth Rogoff present evidence that recessions associated with systemic financial crises tend to be deep and recovery protracted and the current US economic performance is no exception.

While your humble blogger was reading these articles, my attention was drawn to the fact that the authors did not make a distinction between how policymakers responded to the financial crisis.  Specifically, did policymakers embrace the Japanese Model or Swedish Model for handling a bank solvency led financial crisis?

The authors justify this omission as follows:
Given that all of these crises predate the creation of  deposit insurance in 1933, and that three of the four events predate the establishment of a U.S. central bank, one could legitimately quibble with the claim that the relevant institutions are more comparable across centuries in the U.S. than across advanced countries over the past 30 years. 
We would argue that our 2009 international postwar benchmarks, along with comparisons for the recent crisis, are more relevant.
Actually I have a different quibble.  The issue of "how" policymakers respond is important because presumably policymakers learned from previous systemic financial crises and see what did and did not work.

For example, in the 1870s, Walter Bagehot looked at previous bank solvency led financial crises and concluded that there was a need for a lender of last resort.  This role of lending freely at high interest rates against good collateral was assigned to what has become the central banks.

In the US, the Fed only emerged as a central bank in 1913.  Its first systemic financial crisis was the Great Depression.  Not surprisingly, the Great Depression was a learning experience in how to use its lender of last resort capabilities.

As described by the NY Fed, FDR broke the back of the Great Depression with his bank holiday.  During a fireside chat, FDR effectively introduced a guarantee of all bank deposits for the banks that were allowed to reopen.

Not only did FDR put the credit worthiness of the US behind the bank deposits, but he also effectively committed the Fed to lend against the assets of the reopened banks should the run on the banks continue.

Regular readers know that FDR also effectively invented the Swedish Model.  He forced the banks to recognize upfront the losses on their balance sheets.  Only those banks that were capable of generating earnings were allowed to reopen.  The rest were resolved.

Sweden learned from this when it had its systemic financial crisis in 1991.  That is not to say that Sweden didn't make policy mistakes.  It did.  One mistake was made by its central bank in not allowing its currency to float.  This mistake slowed the pace of recovery.

Iceland learned from both the US experience in the Great Depression and Sweden's experience.  It recognized that requiring the banks to recognize upfront the losses they would ultimately incur on the excess debt in the financial system would both protect the real economy and save the social programs.

Not surprisingly, Iceland's implementation of what I call the Swedish Model produced the best recovery.  Five years after its systemic financial crisis, Iceland's gross domestic product per capita on a purchasing power parity basis has returned to the pre-crisis level.

In their work, Reinhart and Rogoff bury this fact by including Iceland in a 'systemic banking crisis' group with Ireland, Greece, the UK, the US and 6 other countries.  Ireland, Greece, the UK and the US embraced the Japanese Model.
We have not publicly supported or privately advised either campaign.
Nor has your humble blogger
We well appreciate that during elections, academic economists sometimes become advocates.  It is entirely reasonable for a scholar, in that role, to try to argue that a candidate has a better economic program that will benefit the country in the future.

Even when there aren't elections academic economists sometimes become advocates (think the Financial, Regulatory and Academic Complex - FRAC).

But when it comes to assessing U.S. financial history, the license for advocacy becomes more limited, and we have to take issue with gross misinterpretations of the facts.
I agree.  When all the facts are used, we see that the adopting the Swedish Model produces a far superior economic performance than pursuing the Japanese Model.

Economic recovery under the Swedish Model from a systemic financial crisis is short (not surprising as it is the banks that take a long time to recover and rebuild their book capital levels).

Economic recovery under the Japanese Model from a systemic financial crisis is very long (not surprising as the real economy is deprived of capital it needs for growth that is diverted to the banks to support the excess debt).

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