Lesson's from Japan's power brokers

In an interesting column in the Guardian, Will Hutton makes the case for why the response by global policymakers to the financial crisis has been 100% wrong and why there is a need to completely overhaul the policy response.

Regular readers know your humble blogger has been saying this.  Where I differ from Mr. Hutton is what the new policy response should be.

I prefer a return to the policy of financial failure prevention and with it adoption of the Swedish Model for dealing with a bank solvency led financial crisis.  My solution takes advantage of how the global financial system is designed.

Mr. Hutton would prefer a redesign of the global financial system.

Most of us, including many bankers, now agree that the last 25 years have been a dreadful mistake. Western consumers and businesses have too much private debt, with Japan serving as an awesome warning of how that can drag an economy down for decades.

I have advocated for the Swedish Model in my solution because it addresses this excess debt and does so in a way that is supported by the designed of our modern banking system.

Under the Swedish Model, banks are required to recognize upfront the losses on the excess public and private debt in the financial system.  This protects the real economy and the social contract as the real economy is not required to divert capital it needs for growth and reinvestment towards making payments on the excess debt.

Yes, banks will have low or negative book capital levels after recognizing these losses.  However, because of the combination of deposit insurance and access to central bank funding, banks can continue to operate and support the real economy even when they have low or negative book capital levels.

There is a lot of hand-wringing over why regulation was so light-touch and why bankers were allowed to get away with so much. But those were the mistakes of a bygone world;

As your humble blogger has discussed repeatedly, the reason that bankers could get away with so much is that financial policymakers led by the US Treasury and Federal Reserve adopted a policy of financial failure containment.

Under this policy, there was no reason to prevent a financial crisis as the US Treasury and the Fed would simply clean it up afterwards.

Following the US Treasury and Fed's lead, global financial regulators abandoned their responsibility to ensure that market participants had access to all the useful, relevant information in an appropriate, timely manner so they could independently assess this information and make a fully informed investment decision.

As a result, bankers were able to hide large areas of the financial system behind a veil of opacity and profit from investors under-estimating the risk of the securities tied to these areas.

the big question we face now is what to do next....

End the policy of financial failure containment and return to the policy of financial failure prevention.

In Japan, I was simultaneously aware of what a toll two decades of deflation had levied on Japanese society, but also of the compensatory force of Japan's underlying economic strength. 

But gloom and pessimism still suffuse the country. Hiromasa Yonekura, the president of the Keidanren, Japan's all-powerful employers' association, told me that this lack of confidence, in his view unjustified, had become hard-wired into Japan's culture by falling prices. It affected even the birth rate and was the chief cause of Japan's rapidly ageing society. 

Nor is the birth rate the only sign of a society in stress. Young women's role in Japanese society is being knocked back by the fashion for coquettishness and cartoon-style prettiness, complete with singsong voices and contrived ways of walking. It is a return to suffocating traditionalism masked as fashionable faddishness. A society worried about its future becomes socially regressive. 

This is the direct result of the policy of financial failure containment.  The debt and the emotional and monetary costs it extracts from the real economy do not go away just because the government adopts policies to pretend the debt doesn't exist.

Yet Japan's capacity to resist the malign element of deflation is very much greater than our own. It is still the third biggest economy in the world, with some fabulous companies possessing frontier technology, and going global rapidly.... 

Japan's stock of public debt is now even more suffocating than private debt.... 

There is an intense private battle raging between the Ministry of Finance and the Bank of Japan. Either the bank starts monetising public debt, as Turner argues, or the Ministry of Finance will launch another unthinkable, unilateral reduction of Japan's public debt burden by demanding borrowers accept worse repayment terms. Plans are being laid for a managed default unless the Bank of Japan prints money.

This is what happens when societies face impossible demands. 

To sustain the social fabric, investment and innovation, governments have to do non-conservative things – reframe their capitalism and break conservative financial rules....