By Michael Pomerleano

Martin’s article “The cautious approach to fixing banks will not work” stimulated me to raise a fundamental issue that is preoccupying me as the crisis unfolds and to which I don’t have an answer.

The standard orthodox prescription suggested by Martin, Krugman and others is to contain the systemic banking sector crisis with a set of comprehensive policy measures that include a rigorous assessment of major banks’ balance sheets, removal of non-performing loans from banks’ balance sheets, and banks recapitalisation. Virtually all the analysts point out the spectre of the Japanese lost decade, and applicable lessons for the recent US crisis. Recently two papers address the Japanese crisis: Lessons from Japan’s Banking Crisis, 1991-2005 by Mariko Fujii Research Center for Advanced Science and Technology University of Tokyo and Masahiro Kawai, Asian Development Bank Institute, and Hoshi Takeo and Anil K Kashyap. 2008, “Will the US Bank Recapitalization Succeed? Lessons from Japan”, NBER Working Paper 14401, Cambridge, Massachusetts: National Bureau of Economic Research.

The Fujii-Kawai paper concludes with the following: “Acknowledging the extent and depth of the bank balance sheet problem - potential loan losses - is the first step toward resolving a banking crisis. In this regard, once the government determines a rough estimate of the size of the crisis, prompt action to recapitalize the banks that are viable, but are under-capitalized is an effective measure to restore market confidence and stabilize the banking system. Then removal of impaired assets from bank balance sheets is the next step.”

In reading the Fujii-Kawai paper I find some of the data striking. First, a chart that points out that the urban land price dropped from an index of 400 in the 1990s to 100 now. Similarly, the concentration of bank lending in real estate was very high. In “Japan’s lessons for a world of balance-sheet deflation”  (February 17), Martin cites an analysis of what happened to Japan is by Richard Koo of the Nomura Research Institute; The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession (Wiley, 2008) and discusses the deleveraging process of balance-sheet financed by debt. Following the unfolding of the US bubble in real estate, in makes me far more sympathetic and understanding of the Japanese authorities’ dilemma in the early 90s. Intervention - assessment of major banks’ balance sheets, removal of NPLs from bank balance sheets, and bank recapitalization - at any point in the early 90s was equivalent trying to catch a “falling knife”. Not sure that no amount of intervention can stop the deleveraging process. My take from this data is fairly straightforward - the process of deleveraging and accrual of bad debt is dynamic and creates a vicious cycle, and no amount of government intervention would have or should have tried to stop the market forces and deleveraging process.

It leads to the following question: what does Japan’s “lost decade” teaches us?  While the standard prescription to intervene promptly is very nice to present, maybe we need to turn things upside down, and look at them in a different light. In a recent talk on the “Challenges to the Global Economy” at MIT (March, 2009) Martin Feldstein gave a very nice lecture outlining similar dynamics re the housing prices in the US. In America, Zillow Real Estate estimates that the downturn in home prices has left about 20% of homeowners owing more on a mortgage than their homes are worth. We are in a vicious cycle, with more houses getting foreclosed and coming to the market, leading to further price declines. A similar deleveraging process has to take place in commercial real estates, such as retail. Deutsche Bank has recently released sobering estimates regarding the prospective losses in commercial real estate. Equally, in light of the lost real estate and equities wealth, the household sector has to deleverage. Defaults in consumer credit are likely. 

The evidence leads me to my counterfactual question. Can the deleveraging process be stopped through fiscal interventions? Admittedly, it will be interesting to quantify the losses and calculate the costs of intervention to assess if intervention is feasible by looking at the aggregate numbers before answering the question. I have not analysed the aggregate numbers for the US, UK or Spain.  But I doubt intervention is feasible. So maybe we need to drop the orthodox prescription to contain this systemic banking sector crisis, such as:  

• rigorous examinations of the credit quality of the major banks’ balance sheets, such as the US government’s stress tests, are a pointless exercise when credit quality continues to deteriorate;
• removal of non performing loans from bank balance sheets is pointless because it addresses the present stock of non performing loans and not the flow;
• and bank recapitalisation is ineffective when the flow of non performing loans will lead to future losses.  

My sense is that in the US, even if intervention on the order of magnitude required was feasible (and I doubt it), the political will, financial resources, and economic wisdom to intervene to offset the assets and wealth losses are simply not there. So as painful as it is, maybe the leveraging process has to proceed and the government should stand by ensuring only the payment system, and facilitate the deleveraging process.

I realise those conclusions are unconventional. Comments are welcome.

By Brendan Brown

Global equity markets are understandably not taking seriously the ominous pessimism from commentators dissatisfied with the notion of an economic recovery emerging from below.

Yes the S&P 500 may be down a few per cent in recent days but that is mainly a reflection of the US dollar’s mini-rebound (which means foreign earnings become worth less in US dollar terms) and some long overdue downward correction (very small so far) in commodity markets. Continue reading "Economic woes: this is not a tale of two depressions"

The following is Martin Wolf’s testimony to the Senate Committee on Foreign Relations in the US, March 25, 2009

We are experiencing the most dangerous financial and economic crisis since the 1930s. But it is also a crisis for foreign policy: a deep recession will shake political stability a across the globe; and it threatens the long-standing US goal of an open and dynamic global economy. Perhaps most important, the US is currently seen as the source of the problem rather than the solution.

This crisis is, therefore, a devastating blow to US credibility and legitimacy across the world. If the US cannot manage free-market capitalism, who can? If free-market capitalism can bring such damage, why adopt it? If openness to the world economy brings such dangers, why risk it? As the shock turns to anger, not just in the US, but across the world, these questions are being asked. If the US wishes to obtain the right answers, it must address the crisis at home, and do what it can to rescue innocent victims abroad. This is not a matter of charity. It is a matter of enlightened self-interest.
Continue reading "US foreign policy and the global financial crisis"

Another ideological god has failed. The assumptions that ruled policy and politics over three decades suddenly look as outdated as revolutionary socialism.

“The nine most terrifying words in the English language are: ‘I’m from the government and I’m here to help.’” Thus quipped Ronald Reagan, hero of US conservatism. The remark seems ancient history now that governments are pouring trillions of dollars, euros and pounds into financial systems. Continue reading "Seeds of its own destruction"

The Nice – non-inflationary, consistently expansionary – decade has gone. The next decade is going to be nasty. It is time to start learning lessons. “Niceness” proved a mistake.

The UK economy has moved with brutal speed from what Andrew Haldane, the Bank of England’s new executive director for financial stability, in a brilliant paper*, calls “the golden decade” of steady growth and low volatility to its opposite. Stability has proved the economy’s nemesis, as Hyman Minsky predicted.

Today, the UK is confronting a painful legacy: the collapse of the housing market and the financial sector; high levels of household debt; evaporation of government revenue; huge fiscal deficits; and assumption by the government of responsibility for a banking system whose aggregate balance sheets are close to five times gross domestic product. This is scary.

The remainder of the article can be read here. Debate from our panel of economists appears below.

What has Japan’s “lost decade” to teach us? Even a year ago, this seemed an absurd question. The general consensus of informed opinion was that the US, the UK and other heavily indebted western economies could not suffer as Japan had done. Now the question is changing to whether these countries will manage as well as Japan did. Welcome to the world of balance-sheet deflation.

As I have noted before, the best analysis of what happened to Japan is by Richard Koo of the Nomura Research Institute. His big point, though simple, is ignored by conventional economics: balance sheets matter. Threatened with bankruptcy, the overborrowed will struggle to pay down their debts. A collapse in asset prices purchased through debt will have a far more devastating impact than the same collapse accompanied by little debt.

Most of the decline in Japanese private spending and borrowing in the 1990s was, argues Mr Koo, due not to the state of the banks, but to that of their borrowers. This was a situation in which, in the words of John Maynard Keynes, low interest rates – and Japan’s were, for years, as low as could be – were “pushing on a string”. Debtors kept paying down their loans.

The remainder of the article can be read here. Debate from our panel of economists appears below.

By Stephen Grenville

With the US official interest rate now in effect zero, there is much talk of monetary policy “running out of ammunition” and “pushing on a string”. Has monetary policy become impotent in the US and Japan? Does a similar fate await the rest of us? Continue reading "Does monetary policy still work?"