He points out that the UK has pursued the Japanese Model for handling a bank solvency led financial crisis for five years and the UK looks like it will match the Japan's experience of a lost decade of economic growth or worse.
The economic stagnation/decline is the direct result of the policies that are pursued as a result of choosing the Japanese Model and protecting bank book capital levels and banker bonuses at all costs.
These policies place the burden of the excess debt on the real economy. To service this debt, the real economy has to divert capital that is needed for growth and reinvestment. The result is at best a Japan-style economic slump.
Vincent Reinhart, Morgan Stanley’s chief economist who was a senior US Federal Reserve official and is the author of seminal papers on post-financial crisis responses, thinks there is an alternative, though. That there is a quicker way back to prosperity.Regular readers are familiar with my seminal work on this blog on how to respond to a bank solvency led financial crisis.
Mr. Reinhart confirms that adopting the Swedish Model restores prosperity quicker. But then, anything is faster that the Japanese Model which as Japan is currently showing, doesn't work.
“A financial crisis is really about an enormous loss of wealth,” he told me at the Word Economic Forum in Davos. “And it’s only when you recognise that loss of wealth that you can set about rebuilding.”
What he was talking about was writing down private sector debt – that of over-borrowed households, companies and banks.
According to the Bank of England, there may be as much as £60bn of unrecognised losses in the UK.
Writing down that amount of debt would normally lead to an awful lot of pain – with some families losing their homes and jobs lost as companies go bust. But if the debts aren’t written down, the rest suffer too.
“If you buffer the people who made bad decisions from their wealth loss, then the people who didn’t make bad decisions suffer a wealth loss too,” Mr Reinhart said.
That manifests itself in a long period of slow growth and - worst of all - youth unemployment.
Effectively, the innocent victims of the recession end up being the ones that also pay for it.Confirmation that pursuing the Japanese Model makes the situation worse. At the beginning of the financial crisis this was referred to as socializing the losses.
The politicians and bankers structured the socialization of the losses so well that the bankers didn't even suffer a significant interruption in their stream of bonus payments.
A little bit of honesty here from the political classes would go a long way, Mr Reinhart reckons.
In the wake of a major financial crisis, he said, the authorities have two options: denial - letting banks, companies and households pretend they can service their debts and sparing them short-term pain.
Or forcing writedowns upfront. Individuals would suffer and unemployment would almost inevitably rise, but the country would get over the hump quicker.
“How long would those laid off be out of a job, though,” Mr Reinhart said optimistically.As shown by Iceland, the recovery is very quick when the Swedish Model is adopted and banks are forced to recognize upfront the losses on the excess debt in the financial system.
Effectively, his second option prescription is classic economic “creative destruction”.
Mr Reinhart is not some misguided hairshirt ideologue, though. He has studied in detail the 15 biggest financial crises since the Second World War, and worked on the issue with the world’s foremost authorities – his wife Carmen and Harvard economist Ken Rogoff.
According to his research, the “more successful economies were the ones where you recognise losses, take writedowns and get over it early”.
“The incomplete recognition of losses means a prolonged period of below par growth.
You never really grow your way out of a debt problem, you limp out. If that’s the case, you have to do QE1, QE2, QE infinity,” he said.Not clear that you can ever grow your way out of a debt problem except in an economics paper.
Mr. Reinhart's observation also confirms the prediction that your humble blogger made at the beginning of the financial crisis that the global economy would remain in a downward spiral (despite brief respites when aggressive fiscal and monetary stimulus is pursued) until such time as transparency was brought to all the opaque corners of the financial system.
When transparency is brought to all the opaque corners of the financial system, it drives the adoption of the Swedish Model. Why? Because market discipline forces the banks to recognize upfront the losses on the excess debt in the financial system.
Of course, this prediction and recommendation about how to handle a bank solvency led financial crisis occurred before Professors Rogoff and Reinhart started talking about financial crises and "This Time Its Different". Their message was that regardless of what was done, it takes years to recover from a financial crisis.
This was precisely the message that the bankers wanted to hear and they repeated it constantly to the policymakers. The result was the adoption of the Japanese Model.
Please note, that the work of Professors Rogoff and Reinhart was fundamentally flawed. It assumes no learning curve in how to deal with bank solvency led financial crises.
In fact there was a significant learning curve. In the 1870s, Walter Bagehot introduced the concept of a modern central bank. In the 1930s, the FDR Administration introduced deposit insurance. The combination of deposit insurance and access to central bank liquidity in fact makes adoption of the Swedish Model possible.
As shown first by the FDR Administration in breaking the back of the Great Depression and later by Sweden, pursuing the Swedish Model works and ends the bank solvency led financial crisis. Of course, Iceland showed that even with a less than perfect implementation of the Swedish Model an economy can recover quickly from a bank solvency led financial crisis.
QE brings its own problems by distorting market behaviour and perpetuating the problem of “zombie banks, zombie companies, and zombie households”.
“The attrition can last a really, really long time,” Mr Reinhart said, citing Japan’s two “lost decades”.Confirmation of all the posts your humble blogger has written about the headwinds generated by zero interest rate and quantitative easing policies exceeding the benefits of pursuing these policies.
So where does that leave the UK?
First, his argument suggests policymakers are not being entirely honest with the public. Patience is not the only option. Aggressive debt restructuring is another.Your humble blogger has been pointing out the two options and why aggressive debt restructuring is the preferred choice.
The problem is, as Mr Reinhart pointed out, that the taxpayer would almost certainly have to step in – to recapitalise the banks as they wrote off billions of pounds of bad lending, or to protect households by capping their maximum loss.
The US stepped into help householders in the 1930s under President Roosevelt, and the idea has been recently endorsed by the International Monetary Fund no less..This is a classic example of economists not understanding how our financial system is designed.
Yes indeed, the US stepped in to help households in the 1930s. The FDR Administration did this by creating deposit insurance.
It is the combination of deposit insurance and access to central bank funding that allows banks to operate with low or negative book capital levels. With deposit insurance, the taxpayers effectively become the banks 'silent equity partners' when the banks have low or negative book capital levels. This allows the banks to both recognize the losses on the excess debt in the financial system and continue to operate and support the real economy.
Since the taxpayers are already the banks' silent equity partners when banks have low or negative book capital levels, there is never a reason to step in and recapitalize the banks.
Instead, the banks with a franchise capable of generating earnings before banker bonuses should retain 100% of their earnings until they have rebuilt their book capital levels. The banks that do not have a franchise that is capable of generating earnings should be resolved.
According to Mr Reinhart, the instruction for banks to write down their assets would have to come from the financial regulator – in the UK in future, the Bank of England.
But the decision would need to be made politically....Mr. Reinhart is right that it is the politicians who have to make the decision to require the banks to recognize their losses.
It is the politicians who have to decide whether they put their country's citizens first or the bankers who fund their elections and retirements first.
To date, every day since the beginning of the financial crisis on August 9, 2007, the politicians have put the bankers ahead of the citizens.
Ideally, this would be when to use quantitative easing. The economy would suffer a brief shock as a result of the hurt households were feeling and as unviable businesses went bust.
Low rates and cheap money would be the cushion to ease the blow.It should also be combined with stimulative fiscal policies to be sure that the real economy fully recovers.
Instead, Mr Reinhart reckons, QE is being used because politicians are failing to take the big decisions: “Of the – say - 15 things that need to be done, QE is number 15. It’s just that the other 14 aren’t happening.”
“I think of it like one of the old service comedies. The commander asks his troops to volunteer for a dangerous but vital mission and they all take a step back except one guy – the hapless hero. That’s the central bank. Because of the failure of politicians to address the real issues, you’re left with the hapless hero trying to do the right thing.”
There is some evidence the UK is trying to grasp the debt restructuring nettle.
The Bank of England is currently forcing banks to declare their hidden losses. But, the Treasury has made it crystal clear that the taxpayer will not be forking out a penny more, which will limit the policy’s effectiveness.
As much as £100bn of mortgage debt in the UK is in forbearance, where borrowers are struggling to keep up with their monthly payments even with interest rates at a record low, the Bank has estimated. The writedowns on that may not be huge, but when taken with overvalued commercial property and other hidden losses, it’s easy to get to a figure of £60bn of writedowns, using Bank calculations.Forcing is too strong a word to describe the request from the Bank of England's Financial Policy Committee that banks disclose their hidden losses.
If the UK financial regulators were serious about forcing the declaration of the hidden losses, the financial regulators would enforce existing disclosure laws and require the banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
With this disclosure, market discipline would force the banks to recognize the losses on their dud exposures.
If there is a country that needs to address its private and banking sector debts, as well as the public ones, it is the UK. Mr Rogoff told me at Davos that “by and large Britain is having a typical post financial crisis period, exacerbated by the dependence on the financial sector and the eurozone”.
In other words, we’ll grow anaemically for a decade at least. “Patience” is the authorities’ euphemism for what they used to call “a lost decade”.
If that’s the choice they have taken, fair enough. But Britons – in particular the younger generation who can not get on the housing ladder and are struggling to find a proper job - deserve at the very least to be told there was another option.Actually, the elderly who vote need to be told their is another option too. After all it is their retirements that are being damaged by the pursuit of very low interest rate policies.
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