The BIS recently released an excellent paper comparing the current crisis to the Nordic crisis. This is a particularly interesting case study because the Nordic credit crisis was relatively clean for a credit crisis. Perhaps most interesting is the fact that their crisis was unfolding at the same time as the Japanese crisis. The results, however, were dramatically different. I believe the thoughts from the BIS are particularly interesting as I was a proponent of the harsher Swedish Model – a bit more of an Austrian economics approach to the crisis as opposed to the Japanese model of trying to ensure capitalism without losers. In recent months the USA is looking more and more Japanese and the BIS believes it is due to our flawed response:
“Our analysis indicates that current policies have followed those (Nordic) principles in some respects, but have fallen short in other, arguably more important, ones. If anything, the authorities have intervened even earlier than in the Nordic precedent. In the current episode, the down-leg of the financial cycle had not proceeded as far and banks were further away from the point of technical insolvency. However, the underlying weakness in balance sheets has not been recognised as fully. Efforts to write down assets and induce underlying adjustment in the sector have not been as extensive. Impaired assets have been kept on balance sheets at highly uncertain, and possibly inflated, values. The conditions attached to financial support have not been as strict with respect to asset and cost reductions; if anything, they have been designed with an eye to sustaining lending. The need to reabsorb the sector’s excess capacity has taken a back seat. All this has tended to slow down resolution.
In other words, the zombie banks live on just as they have in Japan. But perhaps most important is the fact that the losers have not been allowed to lose. Government intervention has only kicked the can down the road. The BIS detailed the successful principles involved in a swift crisis response and sustainable recovery:
Principle 1: Early recognition and intervention
P1: The nature and size of the problems should be recognised early and intervention should follow quickly.
The purpose of early recognition and intervention is to avoid a hidden deterioration in conditions that could magnify the costs of the eventual resolution. This lesson was highlighted, in particular, by the US savings and loan crisis and by Japan’s experience during the 1990s (eg Brewer (1995), Peek and Rosengren (2005), Nakaso (2001)). A key reason why costs tend to increase as action is delayed is that economic agents operate under distorted incentives. If problems are not recognised by outside investors, the cost of funding will fail to adjust upwards. As a result, the financial sector will continue to absorb an excessive volume of resources and misallocate them.
Principle 2: Comprehensive and in-depth intervention
P2: Intervention and resolution should be broad-ranging and in-depth.
The overriding objective is to restore lasting confidence in the financial system and its capacity to operate effectively and sustainably, without public support. Piecemeal policies fail to address the underlying problems and necessitate subsequent policy corrections or reversals. Intervention includes three critical steps: (i) stabilising the financial system; (ii) restructuring balance sheets; and (iii) re-establishing the conditions for the sector’s long-term profitability. Together, these steps should lay the basis for a sustainable recovery.
Principle 3: Balancing systemic costs with moral hazard
P3: Intervention should strike a balance between limiting the adverse impact on the real economy and containing moral hazard.
Each side of this balance represents a legitimate policy objective. The need to strike a balance reflects an underlying tension. On the one hand, intervention is precisely designed to limit the unfettered operation of market forces. The concern is that markets exercise discipline too abruptly and indiscriminately, raising the risk that the financial system implodes and cripples the real economy. On the other hand, that very intervention, by insulating agents from market discipline, may distort incentives (see P1). During the resolution phase, agents may be tempted to abuse the privilege of access to public money. In the long term, they may behave less prudently, sowing the seeds of yet another crisis.
The response by asset prices is dramatic depending on the policy response. As you can see below Sweden and the other Nordic countries experienced strong and/or stable asset performance while Japan recovered periodically only to eventually collapse again as the problems re-emerged:
The USA appears to have succeeded only in Principle 1. Unfortunately, the medicine has not proven to be a cure as we have misdiagnosed our balance sheet recession as a pure banking crisis. In fact, this is a Main Street crisis and not just a Wall Street crisis. Wall Street was simply a symptom and therefore should have been allowed to be more harshly severed.
Principle 2 has been more mixed, however, the very fact that we are discussing more stimulus shows that the government has failed in this regard. Despite two years of efforts and countless dollars spent the US government has failed to fully stabilize the system and has certainly not succeeded in creating a self sustaining private sector recovery.
Principle 3 has been an unmitigated disaster. If there is one thing that has been most destructive throughout this government intervention it has been the extremely high level of moral hazard. The government has initiated policies that target primarily the banking sector while largely ignoring Main Street. The few programs that have been focused on Main Street (such as Cash for Clunkers and the home buyers tax credit) have been largely wasteful. Worst of all, because we have not actually resolved the problems that caused this crisis we have almost certainly sowed the seeds for future crisis.
The BIS concludes that the response has been primarily focused on the short-term as opposed to the long-term. This need for quick results has led to us losing track of the bigger picture and now threatens the sustainability of the long-term recovery:
We have argued that while the current policy response compares favourably in terms of Principle 1, it falls short in terms of Principle 2 and has struck a balance that has been less attentive to containing moral hazard than the Nordic precedent (Principle 3). The main inference is that the current response has favoured the need to sustain aggregate demand in the short term over that of encouraging financial sector adjustment through asset writedowns, the management of bad assets and reduction of excess capacity. By the same token, it has proved harder to maintain a level playing field between those institutions receiving (explicit and implicit) support and the rest.
If this analysis is correct, three implications follow. First, looking forward, there is a risk that the policies followed so far have given too much weight to short-term considerations and too little to their long-term consequences. Establishing the basis for a durably profitable, less risk-prone financial sector may be harder and take longer than expected. By the same token, a self-sustaining recovery may be delayed. Second, it would be desirable for the authorities to intensify efforts to encourage adjustment in the financial sector, rebalancing their priorities. Finally, the interpretation of Principle 1 may need to be nuanced. Unless intervention techniques are adjusted accordingly, there may be such a thing as “intervening too early”.
At this point, unfortunately, we have chosen our path. We have chosen the Japanese “workout” path as opposed to taking our medicine and forcing the losers to be losers. My great fear is that this crisis will weigh on the US economy for many years. Let’s just hope it’s different this time, however, that is rarely the case….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.