The myth that debt must always be repaid

Central to the Swedish Model for handling a bank solvency led financial crisis is the idea that banks are suppose to absorb upfront the losses on the excess debt in the financial system.

Acceptance of this idea runs directly into the myth that debt must always be repaid.

This is a myth because just like investors in stocks and bonds the lender is responsible for both the gains and the losses on their loans.

Prior to making the loan, lenders are able to access all the useful, relevant information about the borrower in an appropriate, timely manner.  Lenders can use this information to independently assess the risk of the borrower.  Lenders can use this risk assessment to set the amount and price of their exposure to the borrower.

Lenders know when they make a loan that not all borrowers will repay.

In normal economic times, when a borrower is unable to repay the loan there is a formal process for restructuring the loan.  It is expected that as a result of restructuring the loan the lender will incur a loss (this is why banks have loan loss reserves).

In a time of a credit bubble driven financial crisis, the formal process for restructuring the loans is overwhelmed by the sheer quantity of loans that need to be restructured.  Policy makers are faced with two choices:  'foam the runway' and drag out loan restructuring until the loans can all go through the restructuring process or create an efficient mechanism for restructuring the loans today.

Like Japan, the EU and the UK, the US chose the 'foam the runway' approach.  I call this approach the Japanese Model as it is designed to protect bank book capital levels and banker bonuses.  It pushes off addressing all the bad debt in the financial system and in doing so effectively forces compliance with the myth that all debt must be repaid (if not by the borrower, then by the society and the real economy).

As part of implementing the Swedish Model, Iceland demonstrated how to create an efficient mechanism for restructuring the loans today.  Iceland established two goals to guide the debt restructuring:

• banks recognize upfront the losses that they would ultimately recognize if the bad loans went through the long formal restructuring process.

• banks losses do not create equity for the borrowers.

These two goals are not mutually exclusive and are designed to protect the real economy.

In his Guardian column, John Sentamu makes the ethical case for having banks absorb the losses on the excess debt.

Today, the poorest in our own societies are paying a very high price for a crisis created by reckless lending by banks and over-the-top borrowing.... 

Ten years ago, we convinced people of the need for a different approach to debt by bringing to mind a very ancient concept – a jubilee, recognising the damage that very large debts can do to society. 

The Hebrew scriptures speak of a jubilee year in which debts are cancelled. They also call for restitution to be made for the damage done by debts – freeing those sold into slavery to help repay debts, returning lands that had been handed to financiers of debt. 

The importance of what might be called "debt justice" to a wider notion of fairness is not limited to Christianity and Judaism. The Qur'an condemns usury and requires zakah (almsgiving) as an essential duty to prevent wealth being accumulated only among the rich.  

Dharmic faiths from the Indian sub-continent teach similar principles, teaching that wealth is held not for oneself but on behalf of all human beings....