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 Richard Robb

In their classic routine, Carl Reiner asks Mel Brooks, the 2000 Year Old Man, to explain how he has managed to live for so long. Brooks replies that he avoids fruits, vegetables, meats, grains - each of which causes some comic side effect. All that’s left for him is “cool mountain water.” “Just that,” the old man says, “and a stuffed cabbage.” Reiner asks whether stuffed cabbage is allowed on his diet. The answer, of course, is “What, you think for a little mountain water I’m gonna keep myself alive?”

Financial risk-taking has come to a similar juncture. Politicians and regulators agree that risk doesn’t belong in banks because it might require another taxpayer bailout. It doesn’t belong in hedge funds either - they are murky and generally wicked. Be sure not to imperil insurance companies or government agencies. And keep risk far away from retail investors, who need protection most of all. Oh yeah, we want risk-taking somewhere so we can have a dynamic economy. It’s our financial stuffed cabbage. Continue reading "Fixing banks quickly"

By Ricardo Caballero

Perhaps one of the economic phenomena most akin to witch-hunting is the diagnostic and policy response that develops during the recovery phase of a financial crisis.  Understandably, pressured politicians and policymakers rush to find culprits and sources of instant gratification. All too often they find a ready supply of these in preconceptions and superficial analyses of correlations.  This time around the scapegoats are global imbalances and leverage. Continue reading "Economic witch-hunting"

Abraham Lincoln famously said that “you can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time”. His successor, George W. Bush, is reported to have added: “You can fool some of the people all the time, and those are the ones you want to concentrate on.” Some British politicians wish to follow that advice in the debate on the public finances. Alistair Darling’s refusal to do that was, it appears, the reason Gordon Brown, the prime minister, wanted to drop him. But Mr Darling is to be praised, not dropped, for his probity. Continue reading "Honesty is the best fiscal policy"

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"

Green shoots are bursting out. Or so we are told. But before concluding that the recession will soon be over, we must ask what history tells us. It is one of the guides we have to our present predicament. Fortunately, we do have the data. Unfortunately, the story they tell is an unhappy one. Continue reading "The recession tracks the Great Depression"

The UK has a strategic nightmare: it has a strong comparative advantage in the world’s most irresponsible industry. So now, in the wake of the biggest financial crisis since the 1930s, the UK must ask itself a painful question: how should the country manage the cuckoo sitting in its nest? Continue reading "Why Britain has to curb finance"