Thursday, April 11, 2013

Harvard's Carmen Reinhart: "The crisis isn't over in the US or Europe"

In her Der Spiegel interview, Harvard economist Carmen Reinhart makes the point that the financial crisis isn't over and the best way to solve it is if debt is written-off.

Furthermore, she points out that the policies that have been pursued to address the problem of too much debt in the financial system are placing the cost of the financial crisis on the real economy and everyday savers.

If this sounds like what your humble blogger has been saying since the beginning of the financial crisis, well....

SPIEGEL: Ms. Reinhart, central banks around the world are flooding the markets with cheap money in order to spur economies and support governments. Are these institutions losing their independence? 
Reinhart: No central bank will admit it is keeping rates low to help governments out of their debt crises. But in fact they are bending over backwards to help governments to finance their deficits. .... 
SPIEGEL: Is that true of the European Central Bank as well? 
Reinhart: Less than for other central banks, but yes. And the crisis isn't over yet -- not in the United States and not in Europe.... 
SPIEGEL: As a historian who knows the potential long-term consequences very well, doesn't such short-sighted decision-making frighten you? 
Reinhart: I am not opposing this change, I am just stating it. You have to deal with the debt overhang one way or the other because the high debt levels are an impediment to growth, they paralyze the financial system and the credit process. One way to cope with this is to write off part of the debt. 
SPIEGEL: You mean some kind of haircut? 
Reinhart: Yes. But we are in an environment where politicians are very reluctant to do write-offs.
Please re-read the highlighted text as Ms. Reinhart has explained both the Swedish Model (where banks  absorb upfront the losses on the excess debt in the financial system) and the Japanese Model (where bank book capital levels and banker bonuses are protected at all costs).

As Ms. Reinhart says, politicians have chosen the Japanese Model.  As a result, the burden of the excess debt is place on the real economy and savers.
So what happens is that money is transferred from savers to borrowers via negative interest rates....
SPIEGEL: So what should be done? 
Reinhart: The best way of dealing with a debt overhang is to never get into one. Once you have one, what can you do? You can pray for higher growth, but good luck! Historically it doesn't happen -- you seldom just grow yourself out of debt. ... 
And the way to ensure that you don't get into a debt overhang is to bring transparency to all the opaque corners of the financial system.  Then, market participants can assess the risk of each of their exposures and limit their exposures to what they can afford to lose.  This puts a cap on how much debt can be in the financial system.
SPIEGEL: But is it not a declaration of bankruptcy for democracy if central bankers, who haven't even been elected, have to step in to fix the problem in the end? 
Reinhart: I think the biggest mistake that European policy-makers are now making is not to put debt restructuring more explicitly on the table. 
Ms. Reinhart calls for adoption of the Swedish Model.
SPIEGEL: Are you referring to Greece? 
Reinhart: Greece has had its restructuring, that's history. But look at Ireland and Spain. Private senior bank debt has not been written off, despite the fact that underlying asset prices in those countries have collapsed and are still collapsing. 
SPIEGEL: So closures of some banks would be helpful? 
Please note that banks recognizing the losses on the excess debt in the financial system may or may not lead to bank closures.

Banks are designed to be able to absorb these losses and continue to operate and support the real economy.  They can do so because of deposit insurance and access to central bank funding.  With deposit insurance, the taxpayers effectively become the banks' silent equity partners when the banks have low or negative book capital levels.

A bank can continue in operations so long as the interest income it generates on its assets exceeds the interest expense on its liabilities plus its pre-banker bonus operating expenses.  The excess earnings can be retained and used to rebuild bank book capital levels.

The only banks that need to be closed are those that where the interest income on their assets is less than the interest expense on their liabilities plus their pre-banker bonus operating expenses.
Reinhart: What is sacrosanct about bank debt? 
SPIEGEL: Well, the bankruptcy of banks can have a considerable effect on the financial system. 
Reinhart: Let me be a little blunter: A haircut is a transfer from the creditor to the borrower. Who would get hit by a haircut? French banks, German banks, Dutch banks -- banks from the creditor countries. So you can see why this is politically torched. This is why it is not done, it's a redistribution. But ultimately it is going to happen, because the level of debt is too high. 
As Ms. Reinhart says, ultimately the Swedish Model will be adopted and banks will be required to recognize their losses.  The question is how much damage to the real economy and the social contract will occur before politicians accept this fact.

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