Balance Sheet Recession

[Gumby]

Interesting data from Japan. In his updated May 2011 presentation, Richard Koo explained what happened when Japan cut spending prematurely.

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Spending went down, tax revenue went down, deficits went up by ¥103.3 Trillion.

The full set of presentation slides can be found here:

The World in Balance Sheet Recession: What Post-2008 U.S., Europe and China Can Learn from Japan 1990-2005

You can also watch a video of Koo explaining the presentation here:

http://www.youtube.com/watch?v=OWGDWYB5KZ0

[moda0306]

I think this is exactly what we are going to get ourselves into with this austerity.  Dispite any moral ponderings of redistribution, The Confidence Fairy & The Bond Vigilantes are myths right now.  Somehow, were in a "deficit crisis" but tax hikes of any kind are completely off the table.

I think of a population with bad credit scores and maybe 2 misdemeanors on their record and what they will ever do to get a job over the next decade.  Not that I feel so horribly bad for people that make mistakes, as much as I see an entire population of brains and bodies going to waste in a long economic malaise.

How a bunch of freshment congressman are steering this country is beyond me.

[MediumTex]

Few people seem to have a strong grasp of the concept of a balance sheet recession.

I think that's part of the reason that the policy response has been so ineffective thus far.

[moda0306]

What do you think the proper policy is, MT.... I feel like I've heard you have issues with Keynesianism, but also claim that austerity doesn't work.

I often view us in the U.S. private sector as a collection of balance sheets... and that our prosperity, in the long-run, depends on those staying relatively strong.  This is why I have bias towards Keynesian-esque ideology... though I share many of the typical concerns.

[MediumTex]

What do you think the proper policy is, MT.... I feel like I've heard you have issues with Keynesianism, but also claim that austerity doesn't work.

What's the correct policy response when you get up in the morning and realize that the horse got out because someone left the barn door open?

In my view you can go look for the horse or buy a new horse.  Closing the barn door is a comically ineffective thing to do, but that seems to be the basic policy response thus far.

First, unrepayable debts need to be written off.  Unfortunately, our system is so over-leveraged and the financial interests have so much politicial power, this won't happen.

Second, assets need to find their market value without the government and Fed trying desperately to recapture bubble-era price levels.

Those two things would go a long way toward getting the horse back in the barn. 

Importantly, too, I think we should have a serious discussion about how not to leave the barn door open in the future once we get the horse back in.

To a degree that most people don't want to admit, the current problems we are facing were set in motions by causes that can no longer be mitigated by ANY policy response.  It's like illnesses that arise following radiation exposure--by the time the illnesses present themselves, the window on any meaningful mitigation of effects has already closed.  By that time, as they say, "it's all over but the crying".

[stone]

Medium Tex, what precise mechanism are you suggesting to get asset prices to realistic levels and bad debts written off? I think the current system is trying to create an enviroment in which banks can "earn their way out of there losses" ie creating a gravy train for the banks to loot the rest of the economy.
You have said previously that money could be doled out to every citizen. I do think that that would cure the recession. I also think moving tax from the current taxes to an asset tax would counter recession.

[moda0306]

MT,

Are you in favor of simply letting asset prices fall and loans default using our current bankruptcy system, or do you see the government devising a more streamlined approach to allow this to happen with less instability and a "rush to the exits," if you will.

[MediumTex]

MT,

Are you in favor of simply letting asset prices fall and loans default using our current bankruptcy system, or do you see the government devising a more streamlined approach to allow this to happen with less instability and a "rush to the exits," if you will.

Well, I think that the banks need to be honest about what they have on their balance sheets.  Without coming clean on this front, there's no way to figure out what will be needed to get them healthy again.  The FDIC has procedures for winding down the affairs on insolvent institutions. 

As far as letting asset prices fall, I don't think it is a matter of "letting" them fall, the fact is if that if current prices do not reflect the underlying supply and demand dynamics they WILL fall, it's just a matter of how long the Fed and co. are going to prevent this from happening, ala Wile E. Coyote hovering in the air before he begins to plummet to the ground after wandering off the edge of a cliff.

As far as defaults go, it seems like common sense to me that if a loan is un-repayable, it won't be repaid.  If this is the case, the sooner you can get those loans off the books the sooner you can start the rehab process.  One hugely helpful thing would be to simply forgive a large part of outstanding student loan debt.  This debt was taken on in many cases based upon a deeply flawed set of assumptions, and it is going to hold back an entire generation's lifetime economic activity.  I think this would be a good investment (but that's just me--I don't personally have any student loan debt).

As far as how all of this would play out, it would be a multi-faceted process.  We would want to use the existing bankruptcy rules, plus some special rules for the various debt amnesty periods that would be available.  The FDIC procedures would be used for some of the zombies, but there would probably need to be a savings and loan-era RTC-type entity to assist in the reorganization of the surviving entities.

In many ways, the overall effort would resemble a salvage operation in its early stages, but it would lead to the re-assembly of the pieces in a way that would provide a basis for a return to some kind of durable economic health.

What we are doing right now just seems like playing musical chairs on the deck of the Titanic (that's a grotesquely mixed metaphor, but I think it captures where we are).

[Storm]

MT has some great points.  Bankruptcy, like death in evolutionary biology, is the way the free market is supposed to clean out the underperforming loans and bad assets so that financial institutions can clear their balance sheets and either go out of business or start fresh and begin lending again (using better qualification standards next time).

We won't really know which banks are solvent and which should be euthanized until we start clearing the bad loans from their books.

Congress has avoided this like the plague because they are afraid of what would happen if additional $trillions in fantasy home equity were wiped out overnight.  The fantasy home equity shouldn't be there in the first place, but it makes the banks look solvent and it keeps the people happy because they think they only lost 10 or 20% of their home value when it really should be more like 40 or 50%

As long as congress insists on policy that tries to artificially inflate asset prices back to even more absurd fantasy levels, we are destined to have a slow economy and a real recovery and growth cannot begin.  What's even worse is that the asset prices will inevitably collapse anyway, all they can do is waste trillions trying to delay the inevitable.

Here's what should happen:

1.  Eliminate the mortgage interest tax credit.  Homeowners should not be rewarded for overpaying on a house, using interest only loans to maximize the tax credit, and then strategically defaulting if the house loses value (which it inevitably will).

2.  Eliminate all programs that artificially inflate house prices - first time home buyer credits, payola to the banks to modify loans, etc.

3.  Severely limit Fannie and Freddy's ability to write new loans that are not strictly conforming, 20-40% down, no more than 2.5 times annual household income, etc.

4.  Re-establish mark to market accounting rules - all banks must now list mortgages and assets on their books at the real values they are worth.  Mortgages that are in default should not be listed at full face value.

5.  Send in the FDIC and break up the banks that are in the red.  Using the new mark to market accounting rules, if your bank does not meet strict reserve requirements, break it up and sell of the assets at a fire sale.

Those 5 things right there would probably put the housing market in a nose-dive, but after about 18 months of a rough time, we'd have all the bad assets cleared from the system and we could begin a real growth recovery of 5-10% GDP for the next decade.