Hong Kong Monetary Authority blasts Japanese Model and related monetary policies

Hong Kong Monetary Authority Chief Executive Norman Chan gave a speech (hat tip Zero Hedge) in which he eviscerates the Japanese Model for handling a bank solvency led financial crisis and its related monetary policies.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  One of the ways of providing protection is to engage in monetary policies like zero interest rates and quantitative easing to artificially increase asset prices.

The Japanese Model has failed 100% of the time that it has been implemented.  It fails for several reasons including:

First, it puts the burden of the excess debt in the financial system on the real economy.  This diverts capital from reinvestment and growth to debt service.  The result is a Japan-style economic slump.

Second, it reduces demand by savers who respond to lower earnings on their savings by making up the shortfall by reducing current demand.  A headwind that contributes to the Japan-style economic slump.

Third, it interferes with the ability of banks to make loans. As a senior secured lender, banks have to be able to value the collateral and they know that the artificial price for the underlying collateral is not sustainable.  One of the ways they know the collateral prices are artificial is that the monetary policies allow them to engage in 'extend and pretend' with their bad debt and turn the debt into 'zombie loans'.

Regular readers know that adopting the Swedish Model for handling a bank solvency led financial crisis is the way to solve our current financial crisis.

Under the Swedish Model, banks are required to recognize upfront the losses on the loans that they would ultimately realize if the loans went through the long process of default and foreclosure.

Having the banks recognize the losses protects the real economy as it is not subjected to the burden of carrying the excess debt.

Hong Kong Monetary Authority Chief Executive Norman Chan said Monday that if the process of deleveraging is disrupted by quantitative easing, asset prices might drop sharply and remain volatile.
When delivering a speech entitled the Global Deleveraging: The Right Track at the Hong Kong Economic Summit 2013, Chan said that excessive leveraging, or over-borrowing, in major industrialized countries was the root cause of both the global financial crisis and the more recent sovereign debt crisis plaguing Europe.

Chan said quantitative easing is not a panacea, but it is the exact opposite of deleveraging. In the past three years, quantitative easing had limited stimulating effect on the real economy.

Quantitative easing is not designed to promote de-leveraging.  It is designed to protect bank book capital levels.

See the discussion above about the headwinds created by quantitative easing for why it has had limited stimulating effect on the real economy.

"In order to solve the structural imbalances built up in the past two decades, we must get to the bottom of the problem."

I would like to thank Mr. Chan for calling for adoption of the Swedish Model.

There is a possibility that quantitative easing produces the desired results, which is a very desirable scenario as global economy will return to its normal growth path, he noted.

There is also a possibility that pigs might fly.  In terms of setting the odds, the odds that pigs might fly are several orders of magnitude greater than quantitative easing producing the desired results.

History shows that 100% of the time the Japanese Model has failed.  Japan has been pursuing it for two plus decades without success.

However, there is a possibility that the process of deleveraging is disrupted by quantitative easing, leading to sharp increases in asset prices in the first place. Yet, since such increases are not supported by economic fundamentals, any increase in wealth will be seen as transient.
As a result, households are unwilling to increase spending and in the end, the real economy fails to rebound, if inflationary pressure builds up alongside asset price increases, central banks may consider exiting the market and raise interest rates, the authority's head said.

Please note that your humble blogger recently made this argument that the underlying assumption that the wealth effect would create demand is flawed.  For it to be successful now would require the investors to have amnesia and forget that the market effectively collapsed in 2008/2009 and is only now being artificially supported.

When economic performance, inflation or monetary policy falls short of market expectation, asset prices might drop sharply and remain volatile, he added.

Chan said he was certain that since the outlook for macro economic and financial environment is very uncertain, it is highly possible that large fund inflows and outflows as well as sharp fluctuations in the financial markets will continue to be seen.

"We should all take precautionary measures and get to the bottom of the problem, learn from others' experiences and avoid overstretching ourselves. Otherwise, we may find ourselves being trapped in the debt abyss with no way out," he said.