WSJ's Alen Mattich: forbearance stifles economic growth

In his Wall Street Journal blog, Alen Mattich discusses how regulatory forbearance stifles economic growth.

Regular readers should be very familiar with the arguments that he presents as they have been discussed on this blog repeatedly over the last several years.

The U.K. economy won’t recover until its banking sector is cleaned up and properly recapitalized. 

But until banks are made to recognize their bad debts, this won’t happen. And the government is doing everything it can to keep banks from recognizing their bad debts in the certain knowledge that, were they to do so, the taxpayer would be on the hook for even more capital injections into the financial sector.

Governments are pursuing what your humble blogger has called the Japanese Model for handling a bank solvency led financial crisis.  Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.

By definition this means that the pace of recognizing the bad debt hidden on and off the bank balance sheets is very slow.  The losses on this debt can only be recognized to the extent that the bank has earnings which exceed the combination of a) bonus payments to bankers, b) dividends to shareholders, c) retention of capital to meet new regulations.

As Mr. Mattich points out, government policy assumes that the banks must be recapitalized today.

In fact, banks don't need to be recapitalized today.  They are designed to continue operating and supporting the real economy while they recapitalize themselves through retained earnings.

Meanwhile, any move on the part of banks to put their books on a sound footing would force up foreclosures and business failures, undoubtedly causing the flagging U.K. economy to stumble badly....

Again, this is an inaccurate assumption used to justify government policy.

As shown by Iceland, the banks only need to recognize the losses on the excess debt.  Said another way, the debt for each borrower is reduced to a level they can afford to make the debt service payments on.

The goal is not to create equity for the borrower, but to reduce the debt so that borrowers can actually service the debt.

Despite doing all he could to encourage forbearance during recent years, including maintaining a zero interest rate policy, Bank of England Governor Mervyn King has started to acknowledge the damage it’s doing to the economy — not least that it’s preventing cheap central bank money from passing through to households and businesses.

Forbearance makes people reluctant to provide capital to banks, for fear of what losses the banks might eventually have to declare and it makes the banks themselves reluctant to lend further. At the same time, households and companies benefiting from forbearance are only just treading water, tying up capital and resources that might be more productively used elsewhere.... 

For now, public policy is to maintain the status quo for as long as possible and hope that inflation ultimately allows banks, households and companies to rebuild their balance sheets to the point where normal levels of lending necessary to sustain trend economic growth return. 

The Japanese example suggests this could take a very long time indeed.