Column Finance and the Social Security System 2009.07.15
Recent economic indicators have suggested that the worst may now be over for the global economy. The outlook is still uncertain, but one thing that is clear is that change in our globalized economy, which is now inextricably linked with financial activities, will take place with growing rapidity.
For that reason, a regulatory regime that prevents financial sector excess and asset-price bubbles is essential. Last month, the White House unveiled a robust plan that seeks to do just that. We agree with its intent, and the direction seems reasonable. But we must also ensure that this current crisis is brought to a conclusive end. This requires that we get rid of bad assets and clean up bank balance sheets. As the crisis eases, we have a window of opportunity to develop an effective policy program to restore and strengthen financial stability. The centerpiece of the program must be a determined effort to get banks to dispose of their bad assets and to provide definitive assistance to corporate and household borrowers burdened by debt.
Japan's own experience demonstrates that disposing of bad loans is a depressing and painful job, demanding extraordinary efforts and sacrifice from all involved. Even with the best of intentions, banks may inevitably be tempted to defer action on bad loans, and may instead opt to wait in hope of an economic recovery that will transform the bad assets into prime assets. That could keep zombie borrowers lingering in the market, creating the kind of fear and uncertainty that hinders economic growth. We urge policymakers and the financial community to remember the fallacy of composition that Japan experienced: An economic recovery may well turn any remaining bad assets into good assets, but if a wait-and-see strategy is adopted, with expectations that bad assets will disappear naturally with the economic recovery, the recovery will not gain traction because of the existence of a sizable and growing stock of bad assets.
What should be done? We should immediately start work on forming the future framework of financial regulation, and policy resources should be directed at removing bad assets from the banking sectors of the United States and Europe, while the economy is being supported by fiscal and monetary policies. Japan's experience offers three important lessons.
First, stringent (even excessively stringent) asset inspections and asset evaluations by financial regulators should be repeated again and again, creating an environment that encourages bankers to sell off their bad assets. Without tough asset evaluations by external regulators, banks will be more likely to defer the disposal of bad assets.
Second, if the inspections reveal that a bank is insolvent, the federal government should have sufficient public funds set aside to recapitalize banks with systemic significance. Without these funds, the government will be unable to lean on banks to the extent needed to end the bad assets problem.
Third, recapitalization of the banks is not enough; corporate and household borrowers must be rehabilitated if economic growth is to be sustainable. Debt-ridden firms and households cannot be productive players in the economy and they cause a sustained disruption to economic activity. The government should fully restructure bad assets and provide relief to corporate and household borrowers. While relieved from debt burden, these borrowers should develop brand new and viable business models for sustainable growth.
In the current crisis, the bad assets problem is complicated by its securitized and global nature. This suggests a need for international policy cooperation, and indeed financial regulators could see this as a chance to construct a new global scheme for coordinated action on bad asset disposals and borrower rehabilitation, perhaps involving a global bankruptcy accord or similar arrangement.
Cleaning up bad assets and offering relief to borrowers will be costly and painful for taxpayers. But although the cost to taxpayers looks overwhelming today, it may not be quite as bad as it seems. In the depth of Japan's crisis, economists estimated that the fiscal cost of disposing of nonperforming loans would be staggering, at up to 50 trillion yen. Ultimately, the net cost was around 22 trillion yen. The economic recovery helped, but it is also true that we tend to overstate our greatest fears. Franklin D. Roosevelt famously said, "The only thing we have to fear is fear itself." Similarly, the world today should find the courage to tackle the challenge of removing bad assets.
The current crisis offers its own valuable lessons. The root causes lie in two fundamental challenges for the world economy: global imbalances and environmental limits to growth. The colossal U.S. current account deficit and the corresponding surpluses of China, Japan and emerging markets are a factor for the current crisis and will remain destabilizing as long as they exist. The limits on economic growth imposed by global warming and reserves of fossil fuel, water, and other natural resources are a similarly serious challenge. Solving these problems requires that we do more than just demand that the United States save and China spend, or call for emissions cuts and conservation. We need a new model for capitalism in the 21st century. Both the mature capitalist economy of the United States and the developing economy of China must find sustainable models for this new era of interacting and rapidly changing financial and industrial activities. One solution may be to produce an institutional basis for the development of stable asset markets in surplus countries that provide high-quality opportunities for investment. Our new model demands institutional, normative, and practical changes in the frameworks of developing and industrialized economies alike. This crisis ultimately requires immediate and resolute steps to deal with the bad assets problem and a sustained effort to find a long-term model for the market economy.