Rogoff and Reinhart: recognizing losses on bad debt speeds recovery

In their interview with Barron's, economists Kenneth Rogoff and Carmen Reinhart effectively endorsed the Swedish Model over the Japanese Model for handling a bank solvency led financial crisis.

Under the Swedish Model, banks are required to recognize up font their losses on the excess debt in the financial system.  This protects the real economy.

Under the Japanese Model, bank book capital and banker bonuses are protected at all costs.  This places the burden of the excess debt on the real economy with the result being a prolonged Japan-style economic slump.

What are your thoughts about the steps taken to foster fiscal and monetary policy? 

Reinhart: We can always go back and figure out a way in which the fiscal and monetary policy could have been made sharper, to do more. But the thrust in a deep financial crisis, when you throw in both monetary and fiscal stimulus, is to come up with something that helps raise the floor. That's why the decline wasn't 10% or 12%. 

However, one area where policy really has left a bit to be desired is that both in the U.S. and in Europe, we have embraced forbearance. Delaying debt write-downs and delaying marking to market is not particularly conducive to speeding up deleveraging and recovery. Write-downs are not easy. On the whole, write-offs have been very sluggish. 

Rogoff: Again and again, policy makers, Wall Street economists, and world leaders have all been overly optimistic about how fast things are going to go. If you think that we are about to get a V-shaped recovery, then you talk yourself into forbearance. 

It helps when the bankers are standing there saying the financial system is going to collapse unless their is forbearance.

If you think, "My gosh, this is going to last 10 years, but how can we make it last seven years?" you say, "This is really painful, but we've got to do it." But they've been very slow coming around to the view that this downturn isn't ending soon, and they can't just hold their breath and have it go away.

Your humble blogger has been making this point since the financial crisis began.  Every day policy makers have to make a decision over whether they would like to end the financial crisis sooner or let it drag on.

Every day that policy makers continue to pursue the Japanese Model and forbearance over the Swedish Model, policy makers are choosing to let the financial crisis drag on.

Look at Europe. A lot of policies are directed at keeping European banks afloat, and it is crippling the credit system. You could have said the same about the U.S., where a lot of policies are about recapitalizing the financial system. The policy makers were very, very cautious about breaking eggs. The thinking was, "We just have got to hold out for a year, and it is going to be fine."

Well, everything is not fine in Europe or the US.

Don't take my word for it, just look at the Federal Reserve's recent adoption of permanent quantitative easing.  Is this a monetary policy consistent with everything is fine in the financial system?

What kind of policy makes sense in the U.S.? 

Reinhart: On the monetary side, which for me is the least ambiguous right now, this is not the time to be an inflation hawk. I would rather see the margin of error favor easing too much, rather than too little, for many reasons. The frailty of the recovery is still an issue. The amount of debt that is still out there for households, the financial industry, and the government is still large. 

The fiscal side is more complicated, because the idea of withdrawing stimulus in what is still a frail environment is not an easy one to tackle. However, over the longer haul, a comprehensive, credible fiscal consolidation is very much needed, because as much as we allude to the level of public debt, the level of private debt, external debt, and so on are even higher. And we also have a lot of unfunded liabilities in our pension scheme, a long-term issue that needs addressing. 

But getting back to the earlier point about helping the deleveraging process, we have a credit system that is still working very poorly. 

Right.  So the policy that makes sense for the US is to adopt the Swedish Model and have banks recognize all the losses on the bad debt hiding on or off their balance sheets.