Need for Reform

An air of consternation hangs thick over the skies of North America. The moribund U.S. economy is keeping the unemployment rate high and consumer prices depressed. With the prospects for additional stimulus gone, given the recent electoral outcome, the Federal Reserve was forced into action. The additional $600 billion in quantative easing is expected to raise U.S. economic activity by ¼ of a percent, which will not provide much of a boost. Some pundits believe that the Fed’s real motivation was preventing the economy from slipping into deflation. However, the true driver may be reviving the financial sector by inflating asset prices. The fragile health of the U.S. financial sector remains the main underlying problem.

Policymakers need to restore solvency to banks when faced with a systemic financial crisis. There are several methods that can force banks to clean up their balance sheets. Policymakers can force them to raise capital, which could involve receiving cash from shareholders or the government. They can force them to reduce liabilities, which can be done by writing down bad debts. Finally, it can be done by inflating the value of financial assets. Political and institutional constraints determine which approach policymakers will employ to address their financial sector problems. There is extensive literature that examines the various approaches. The over-riding conclusion is that the best approach to addressing systemic financial crises is to rapidly establish a broad set of criteria that will allow the banks to work through their problem loans, thus laying the groundwork for the start of a new economic cycle.

One of the best examples of this approach was Sweden. During the 1980s, the Swedes experienced a housing boom that soured in 1992—taking down most of the banking sector. The government was forced to inject funds to keep it from imploding. However, the banks were forced to surrender equity and write down bad loans. Existing management was also wiped out. In the end, the cost of the Swedish bailout was 4% of GDP, and the economy was soon on its way to a rapid recovery. A series of subsequent fiscal reforms stabilized the country’s debt load. The government’s decisive action limited the damage and allowed the country to emerge quickly from the crisis. Similar events in Thailand, Malaysia and Mexico also allowed those economies to overcome the effects of a deep financial crisis. However, not all countries are willing to take the necessary measures to overcome systemic problems. Japan, for example, unconditionally helped recapitalize its failing banks, without demanding any restructuring of bad loans. Aided by government support, the banks refused to clean up their balance sheets, and instead focused their attention on marginal businesses. Two decades later, Japan remains burdened by trillions of yen in unproductive assets, weak credit conditions and a moribund economy. Unfortunately, the U.S. is on the same trajectory.

Fed Chairman Ben Bernanke’s quantitative easing may be an attempt to boost bank balance sheets by inflating financial asset prices. Given the overhang of non-performing loans in the U.S., the need by households to clean up their balance sheets and the ongoing legal problems with mortgage foreclosures, banks will probably not be providing additional credit to the retail market. This means that they will probably inject the additional funds into the financial markets. As a result, asset prices will continue to rise—which will then boost balance sheets. The positive wealth effect will help households increase spending, but it will not do much for the employment picture. Construction levels will remain subdued and small firms will not be able to expand. Ironically, the monetary expansion will have an inflationary effect abroad. It will raise the demand for manufactured imports. Likewise, some of the additional funds will also make their way offshore, which will also enhance the level of economic activity in other countries. Clearly, we are seeing inflationary pressures on the rise in India, Australia and China. These central banks already took measures to tighten monetary policy. However, these measures are only sparking more capital inflows. Therefore, quantative easing may provide some relief to the U.S. by boosting the value of financial assets, but it will not do anything to assist in the economic recovery process. In the end, there is no substitute for cleaning up the balance sheet of a failed financial sector.

The lessons of financial crises from around the world are that insolvent banks need to be seized quickly. The management needs to be fired, the equity holders wiped out and balance sheet cleaned up. Failure to do so will leave the economy burdened with the deadweight of a dysfunctional financial system that will prevent it from embarking on the recovery phase of the business cycle.