In defending Japanese Model, Nomura's Richard Koo highlights why the Swedish Model is better choice

In his Financial Times column, Nomura economist Richard Koo tries to defend the Japanese Model for handling a bank solvency led financial crisis.  His defense illustrates why the Swedish Model is the proper response.

Regular readers know that under the Japanese Model bank book capital levels and banker bonuses are protected at all costs.  This includes socializing the losses and shifting the burden of the excess debt in the financial system onto the real economy.  The result is a permanent Japan-style slump or as your humble blogger predicted at the beginning of the financial crisis a downward economic spiral.

Under the Swedish Model, banks are required to recognize upfront the losses on the excess debt.  This saves the real economy and avoids any socialization of the losses.  The result is rapid recovery for everything except banker bonuses.

In 2008, Barack Obama told the US people the nation’s economic crisis would take a long time to overcome. In 2012, many of those voters are losing patience, because they have not been told why this recession has lasted so long or why his polices were the correct response. 

Here is the missing explanation – based on not only the US experience, but also that of Japan and Europe.

As Mr. Koo will show, in fact, choosing the Japanese Model is the wrong policy response to a bank solvency led financial crisis.

In 2008, Iceland also faced a bank solvency led financial crisis.  Iceland chose the Swedish Model.  Four years later, Iceland has put its financial crisis in the rearview mirror.

Meanwhile, where the Japanese Model was implemented, the US, Japan and Europe, the financial crisis continues.

Today, the US private sector is saving a staggering 8 per cent of gross domestic product – at zero interest rates, when households and businesses would ordinarily be borrowing and spending money. But the US is not alone: in Ireland and Japan, the private sector is saving 9 per cent of GDP; in Spain it is saving 7 per cent of GDP; and in the UK, 5 per cent. Interest rates are at record lows in all these countries. 

This is the result of the bursting of debt-financed housing bubbles, which left the private sector with huge debt overhangs – notably the underwater mortgages – giving it no choice but to pay down debt or increase savings, even at zero interest rates.

Actually, there is one more choice:  requiring the banks to recognize their losses on the excess debt.  Specifically, writing down the debt to the level that the borrower can afford the debt service payments, but not so far as to create "equity" for the borrower.

If this choice had been made, with all the fiscal stimulus, the real economy would be surging.

However, if someone is saving money or paying down debt, someone else must be borrowing and spending that money to keep the economy going....

Actually, banks writing down debt doesn't shrink the real economy.

What shrinks the real  economy is when banks do not have to write down the bad debt under the Japanese Model and instead 'collect' payments on this debt that could otherwise have been used to reinvest or grow the real economy.

A form of 'collecting' payment on the excess debt is when the central banks pursue a zero interest rate policy.  This policy results in savers losing out on interest income and the banks benefitting from the decline in their cost of funds.

Naturally, without the interest income, savers spend less, demand for goods and services in the real economy declines and the real economy shrinks.

But when the private sector as a whole is saving money or paying down debt at zero interest rates, the banks cannot lend the repaid debt or newly deposited savings because interest rates cannot go any lower. This means that, if left unattended, the economy will continuously lose aggregate demand equivalent to the unborrowed savings. 

In other words, even though repairing balance sheets is the right and responsible thing to do, if everyone tries to do it at the same time a deflationary spiral will result. It was such a deflationary spiral that cost the US 46 per cent of its GDP from 1929 to 1933.

Please note Mr. Koo's reference to 1933.

Regular readers know that in 1933, the FDR Administration was the first to adopt the Swedish Model and force the banks to recognize upfront their losses on the excess debt.  The FDR Administration did this by declaring a bank holiday and only letting some banks reopen.

Naturally, those that didn't reopen absorbed their losses.  Everyone knew that deposits in the banks that reopened were implicitly guaranteed by the government, later explicitly, and therefore these banks could also realize their losses.

According to the NY Fed, this broke the back of the Great Depression.

Those with a debt overhang will not increase their borrowing at any interest rate; nor will there be many lenders, when the lenders themselves have financial problems.

The Swedish Model attacks the debt overhang by eliminating it.

Regular readers also know that it is in bankers' DNA to make loans regardless of the financial condition of their institution.  This is easily shown by the lending binge that went on during the 1980's US Saving and Loan Crisis.

There is a fundamental reason that bankers make loans.  Originating loans is separate from funding the loans.  Bankers know that there are many financial market participants who will "fund" the loans including insurance companies, pension funds, hedge funds...

This shift from maximising profit to minimising debt explains why near-zero interest rates in the US and EU since 2008 and in Japan since 1995 have failed to produce the expected recoveries in these economies....

There are several reasons excluding deleveraging that explain why near-zero interest rates have failed to produce the expected recoveries in these economies.

As Walter Bagehot observed in the 1870s, savers cannot stand rates of less than 2%.  This observation translated Mark Twain's statement of being more concerned about the return of his money than the return on his money into an interest rate rule for central banks.

When interest rates drop below 2%, they create economic headwinds.  One headwind they trigger is the Retirement Plan Death Spiral.  Under this death spiral, a drop in earnings on retirement plan assets is offset by additional savings by individuals and by diverting capital that was used for reinvestment and growth as contributions to pension plans by companies.

Both of these actions to offset the decline in earnings on retirement plan assets reduce demand in the real economy which further decreases earnings on retirement plan assets... a self-reinforcing negative feedback loop.

Japan, which also struggled with this form of balance sheet recession, managed to keep its GDP above the bubble peak of 1990 despite plunging commercial property values and rapid private sector deleveraging, because its government borrowed and spent private sector savings....

Japan is still dealing with its financial crisis.  Iceland is not.

Recovery from this type of recession takes time because the flow of current savings must be used to reduce the stock of debt overhang, necessarily a long process when everyone is doing it at the same time. Since one person’s debt is another person’s asset, there is no quick fix: shifting the problem from one part of society to another will solve nothing.

Actually, requiring the banks to absorb their losses on the excess debt turns out to be a very quick fix.  This has been shown in the US during the Great Depression, Sweden during its banking crisis and more recently Iceland.

The challenge now is to maintain fiscal stimuli until private sector deleveraging is completed.

As shown by Japan, this private sector deleveraging is never completed.  Japan has been experiencing deleveraging for 2+ decades.

Any premature attempt to withdraw that stimulus will result in a deflationary implosion – as in the US in 1937, Japan in 1997, and Spain and the UK most recently. 

Japan’s attempt in 1997 to reduce its deficit by 3 per cent of GDP – the same size as the “fiscal cliff” now facing the US – led to a horrendous 3 per cent drop in GDP and a 68 per cent increase in the deficit. At that time, Japan’s private sector was saving 6 per cent of GDP at near zero interest rates, just like the US private sector today. It took Japan 10 years to climb out of the hole.

What all this data points to is how important it is that the policy makers stop pursuing the Japanese Model and adopt the Swedish Model for addressing the ongoing financial crisis.

A change in policy that could be made in Europe, Japan, the UK or the US today.