The View From 1776
Thursday, January 22, 2009
Shovel the Stables; Don’t Perfume Them
The credit deterioration stink will not go away until markets are allowed to clear. However painful that may be, it’s quicker and ultimately less brutal than avoiding the real problem.
The global credit crisis and the ensuing economic slump we are now entering have both ultimate and proximate causes. The ultimate cause was the ingrained social behavior of the U.S., the U.K. and many other economies over the past two decades that put instant gratification of consumption over the ability to pay for it. Thrift gave way to borrowing and excessive spending. That in turn led to huge global imbalances and distortions. The proximate cause of the crisis was how these excesses were financed through liquidity creation in innovative ways and in huge proportions.
Understanding these causes can explain why it has become so difficult to solve the crisis. Desperate to preserve the value of asset prices inflated by this huge liquidity bubble, policy makers have avoided the painful solution. The liquidity injections, the bailout programs, and the fiscal-stimulus packages try to sustain asset prices, when these prices need to fall to market levels so they can be cleared. The policy makers have just prolonged the crisis.
I am reminded of the clear conclusions of the World Bank’s thorough analysis in a 2002 paper “Managing the Real and Fiscal Costs of Banking Crises,” which examined banking crises over the past 50 years: “Accommodating measures such as open-ended liquidity support, blanket deposit guarantees, regulatory forbearance, repeated recapitalizations and debtor bailouts appear to increase significantly the costs of banking crises. Did these accommodating policies achieve faster economic recovery? We failed to uncover evidence that they did. Indeed, they seem to have prolonged crises because recovery took longer.”
As we saw in Japan in the 1990s, if the market is not allowed to clear, the financial crisis will be prolonged. Although debt deflation may be avoided, the economic recession will be longer and the recovery weaker.
There is nothing mysterious about the policy steps that need to be taken to get us out of this mess as quickly as possible. It is not rocket science. In fact, it was successfully carried out by the Scandinavian authorities back in 1991. The banks must be forced to disclose their “toxic” assets (the German banks have about 300 billion euros, the U.K. banks probably 200 billion pounds, and the U.S. banks maybe $800 billion). Then these must be written down to market prices with the hit being taken by shareholders and bondholders—but not depositors. If that means most banks become insolvent, then so be it.
...It’s natural for policy makers to say, “We know where the problem at the heart of the credit crisis is: it is a lack of lending and we must get credit flowing.” If only it were that simple. What policy makers on both sides of the Atlantic desire is to sustain household leverage and consumption at any price, when the only exit from the credit crisis involves a return to thrift by the overleveraged. That cannot be achieved painlessly.