Is Obama considering nationalisation?
You may have seen Ed’s post “Gillian Tett: Washington is talking to Swedes about banking crisis solutions” a week back about how the U.S. government was getting ready to talk to Swedish officials regarding the banking crisis. This is a very important development and I have a lot more to provide below on the issue as it pertains to today’s events and Japan’s crisis early this decade.
Bo Lundgren, one of the original architects of Sweden’s successful banking bailout program, went to Tokyo in 2001 (I wrote about it in “Prudent Bear”) and a lot of his ideas were subsequently adopted by Heizo Takenaka, Japan’s Economics Minister in Prime Minister Junichiro Koizumi’s administration.
It is also worth noting that Sweden only nationalised two banks, so the key challenge is minimising the contagion effect (i.e. if you take over Citi and BofA, how can you spare JP Morgan or Wells Fargo?).
But one of the key aspects of the Swedish plan which helped it gain widespread public acceptance was the notion of SHARED SACRIFICE. This gave the nationalisation tremendous public legitimacy. Geithner’s plan looks like it is being directed by Wall Street and in TALF you give them a huge political weapon — i.e., we don’t partner with you if you continue to adopt measures we don’t like.
US calls on Sweden’s “Mr Fix It” Bo Lundgren
The Swedish financial chief known as “Mr Fix It” has been summoned to Washington to advise on how Sweden’s model might avert a global banking meltdown.
Bo Lundgren, the steely-eyed head of Sweden’s National Debt office, played a leading role in averting the collapse of the Swedish banking sector when a property bubble burst in the early 1990s.
Sitting in his office in downtown Stockholm before his trip to Washington, Mr Lundgren chuckled at the Wall Street joke that “Swedish models used to only attract attention if they were blonde and leggy”.
Now, US President Barack Obama cites Sweden as a possible model of how best to tackle failing banks. Mr Lundgren, who was fiscal and financial affairs minister at the time of the last crisis, yesterday outlined the Swedish solution to the Congressional Oversight Panel, which supervises the US administration’s troubled asset relief programme.
“I am a market liberal. I was even called the nearest Sweden had every come to having a party one could call libertarian,” said Mr Lundgren, the former head of the Moderate Party with links to the Conservatives.
This did not stop him nationalising two failing major banks in 1992: the already majority state-owned Nordbanken, and the privately owned Gota bank.
“In the case of a crisis, the state needs to be strong,” he said. “If it decides to act, it should become an owner.”
After initial hesitation, when the Swedes chose to act they soon reached a broad political consensus.
The first, and in his eyes crucial step Mr Lundgren took was to restore liquidity by issuing a so-called “blanket guarantee” for all non-equity claims on Swedish banks.
This was vital to restore confidence, he said, and is something that has not been done in the US and UK.
It was also crucial not to put a figure on the guarantee, according to Stefan Ingves, the governor of the Riksbank, Sweden’s central bank. Mr Ingves was a finance ministry official in the early 1990s and led the Bank Support Authority, created to resolve the crisis.
“If you pick a very low figure, people will say: ‘That’s not credible, we think the problem’s bigger than that.’ If you pick a very high figure, then people say: ‘Oh gosh, is it that big a problem?’,” he said.
The government did not extend its credit guarantee to shareholders of the nationalised banks, who were wiped out.
In the UK, the Royal Bank of Scotland has refused to go this far, but the Swedes insist this acts as a wake-up call to shareholders of troubled but still solvent banks to shape up or ship out. This decision spurred two private banks to raise private capital.
A “stress test” was worked out to determine how bad the problems were in each bank for the coming three years.
Banks were then ranked as healthy or as candidates for nationalisation, and those in between were told to clean up their act or face being taken over by the state.
Next, the toxic assets of the nationalised banks were ring-fenced into two separate bad banks and run by independent asset-management companies. The good assets were placed in a single, merged bank.
As central banks and supervisors “don’t do corporate restructuring”, the Swedish authorities decided to bring in investment bankers from the private sector to run the corporate finance side of the bad banks’ assets. “Huge numbers” of bankers and auditors were flown in from London to do the “daily running of these businesses,” said Mr Ingves.
Private banks were also urged to place their non-performing loans in separate bad banks. However, unlike what has been mooted in the US, there was never any question of the authorities buying bad assets from banks that remained in any way privatised. “We refused to do that because we could never agree on the price. If you pay too much it’s a giveaway to the shareholders. If you pay very little then the transaction simply won’t happen,” said Mr Ingves.
Despite calling it a “political value judgment”, it is clear he disapproves of countries such as Britain and the US who have committed huge sums to insure bad assets of private or part-private banks.
Once split, the two Swedish bad banks managed to liquidate their assets by 1997 and the state recouped at least half the funds it had made available.
While the process worked back then, the two Swedes recognised that the 1990s crisis, essentially home-grown and involving half a dozen national banks, was very different from the current global meltdown, involving far more banks and complex “packaged and repackaged” assets. Still, the solution remains the same, said Mr Ingves, even if far more co-ordination is today required.
“Clearly, one of the lessons that comes out of all this is that in Europe, the financial integration between countries ran way ahead of the EU’s willingness to have a regulatory framework following at the same pace,” said Mr Ingves.
The Swedes also expressed concern that other countries’ handling of this crisis was still too piecemeal.
“In the US, certainly early on, there was no consistent policy over capital injection and bad assets. Now it’s better but there are still too many loose ends,” he said.
“To restore confidence you have to show exactly how big the problems are and how you are going to take care of that.”
Here’s what I had to say on this very topic in 2002 in Prudent Bear as it relates to Japan’s own struggles:
Two Visitors to Tokyo
“Government intervention is unavoidable if non-performing loans and bank loans are mounting in an economy…In order to limit moral hazard problems and to secure public support…it is important to enforce the principle that losses are to be covered in the first place with the capital provided by the shareholders. If that means the banks must be nationalized, so be it.” – Bo Lundgren, former Swedish Minister for Fiscal and Financial Affairs
In addition to President Bush, there have been two other important foreign visitors to Japan in the past month: the leader of Sweden’s parliamentary opposition, Bo Lundgren, and chairman of the executive committee of Citigroup, Robert Rubin. During their time in Tokyo, both men commented on the state of the country’s financial crisis, the gravity of which is being debated yet again in light of the recent strong rise in the Japanese stock market. Needless to say, the visit of the former US Treasury Secretary occasioned much more coverage and corresponding press commentary, but it was Mr. Lundgren, in his discussions of Sweden’s own banking crisis and its unstated implications for Japan, who ultimately imparted far greater wisdom to his hosts.
Reading Mr. Lundgren’s recent speech on the so-called Swedish Solution (delivered at Tokyo’s Swedish Embassy), one is struck by the government’s sheer decisiveness to overcome its problems that struck in the early 1990s. The Swedish financial crisis was entirely resolved within 6 years at minimal cost to the taxpayer, at which point the Japanese authorities were still debating the question as to whether public money was actually required for their ailing banks. In the words of HSBC Securities banking analyst Brian Waterhouse, “The Swedes have finished the ‘race’ and have dealt with their banking crisis; the Japanese are still stuck in the starting gate”. The huge costs of Tokyo’s inactivity are increasingly apparent to many outside observers. The inevitable policy response, which is coming closer in time as crisis conditions intensify, will likely be widespread bank nationalization, a collapse in the value of the yen, and the onset of a rapid rise in inflation.
This might seem an unduly alarmist viewpoint now that Tokyo’s bureaucrats have successfully engineered another year-end ramp of the Japanese stock market over the past month and familiar talk of recovery is in the air. But as appears to be always the case in Japan, the country’s politicians and bureaucrats have yet again wasted valuable time and resources on eradicating the symptoms, rather than the underlying disease of deflation, of which the inexorable rise of non-performing loans in the commercial banking system is the most visible manifestation. The rally in Japanese bank shares has merely deferred the day of reckoning as well as engendering complacency yet again amongst the country’s policy makers. Hence, the respective insights of Messrs. Rubin and Lundgren take on added significance.
First Mr. Rubin. He told Japanese Prime Minster Junichiro Koizumi that the central bank should set an inflation target as a means of alleviating the deflationary pressures current afflicting the banks real estate portfolios and, indeed, the economy as a whole. The case for inflation targeting is certainly not new. Paul Krugman urged this course of action in 1998 when he proposed that the Bank of Japan opt for a policy of controlled inflation. Krugman’s argument for a controlled inflation for Japan arises out of his application of a model that does not incorporate private debts and debt related behavior. To our mind, this would seem to miss the basic issue that most realize is paramount in the current Japanese crisis. Nonetheless, Krugman’s argument has merit and his policy prescription has since been echoed by other commentators.
Economist Andrew Smithers has argued for an eventual inflation in Japan for, in our opinion, the right reasons: namely, that the change from price deflation to price inflation would lead to a consequent reduction in private indebtedness in real terms that would allow for a recovery of domestic demand, the weakness of which is the root cause of Japan’s current economic woes. Whether one accepts the Smithers or Krugman framework, Rubin’s reiteration of this advice is a most surprising departure for a figure who prominently advocated Western style restructuring as the optimal means of turning around the moribund Japanese economy during his time as US Treasury Secretary. Indeed as Treasury Secretary, Rubin publicly warned Japan against pursuing a devaluation policy in the pursuit of economic recovery.
Yet as Japan’s deflationary pressures have intensified, even Mr. Rubin appears to have undergone a Damascene type of conversion on this issue. But the fact remains that an inevitable consequence of establishing a positive inflation target as Rubin now advocates means substantially higher rates of monetary growth and a correspondingly weaker yen. Whether he realises it or not, the former Treasury Secretary’s advice invariably leads back to the export led growth strategy for Japan that he once repudiated.
It is also difficult to speak any longer of a policy of “controlled inflation” that would lead to a gradual decline in the value of the yen. When Krugman and Smithers first began urging this course of action on Japan’s monetary authorities years ago, the deflationary pressures were not quite as severe and the non-performing loans in the banking system had not exploded to the degree they have more recently. Such has been the cost of inactivity amongst Tokyo’s policymakers, however, that far more aggressive and unorthodox measures are needed today than would have been the case some 5-6 years ago when the calls for an explicit inflation target were first publicly made.
What are the consequences of Japan’s wasted decade? If private sector (as opposed to government) estimates of the extent of the bad debt problem in the banking system are correct (anywhere from 25-70 per cent of GDP), then the scale of money now required to nationalize the banks will almost certainly entail huge additional monetary stimulus. The likely aftermath therefore will not be a yen/dollar rate of 135-140, but something closer to 200 yen to the dollar, or possibly higher. Such has been the consequences of a decade of inactivity in Japan that (in the words of AIG economist Bernard Connolly): “– there is no happy medium in Japan, we fear, between deflation and very rapid inflation, and that in turn, we think, means that a yen collapse and very rapid inflation are all but inevitable and are coming much closer in time.”
In light of Japan’s abysmal record on economic policy making over the last decade, it seems ludicrous to analyse the potential consequences of a “successful” inflation targeting strategy. But were the Japanese monetary authorities able to weaken the yen and enable inflation to develop, it would almost certainly be accompanied by a sharp fall in JGBs.
This creates two interrelated problems: The Japanese banking system, which by virtue of its high proportion of non-performing loans, is unable or unwilling to act as a financial intermediary borrowing short from the central bank and lending to Japan’s private sector. Instead, Japan’s banks have taken to borrowing overnight from the central bank at virtually zero interest rates and buying government securities of slightly longer maturity to pick up a small additional 15 or 20 basis points of yield on those government notes. This is virtually their only source of profitability right now.
In this process, Japan’s banks have acquired a huge stock of government debt bearing very low interest rates that mirror the absence of any other investment opportunities in Japan and the total risk-aversion of the banks. As the banks are already heavily exposed to a weak bond market, a weak yen will consequently add to their disinclination to buy more, thereby complicating the BOJ’s efforts to reflate, since bond buying on the part of the banks is essential to keep the money supply from contracting. In the absence of huge increased purchases by the Japanese central bank, the resultant losses stemming from a rout in the bond market will also put the commercial banking system one step closer to insolvency. Hence, we come back to the question of bank nationalization, since a crash in the market value of the banks’ JGB portfolio would in effect merely represent an immaterial accounting transfer within the government were the banks nationalized, rather than another huge private sector loss that would intensify existing deflationary pressures in the absence of public ownership.
The recent visit to Tokyo of Bo Lundgren, currently Sweden’s parliamentary opposition and a former minister for fiscal and financial affairs is highly significant in this regard. Lundgren was a central figure in helping to resolve successfully Sweden’s own banking crisis in the early 1990s. Unfortunately, for the Japanese, while the Swedish solution does provide a blueprint, Lundgren’s analysis also serves to highlight Tokyo’s own remarkable delinquency and the reasons why resolution of the Japanese banking crisis is likely to be more problematic and costly.
To be sure, Sweden’s crisis was not nearly as big as Japan’s, but they might have become as large had the Swedish authorities dithered to the extent that their Japanese counterparts have done throughout the past 12 years. In Sweden, troubled loans were 20 percent of outstanding credit, 12 percent of gross domestic product, compared with (by estimates other than those officially advanced in Tokyo) 20 to 25 per cent of credit outstanding and anywhere from 40 to 70 per cent of GDP in Japan. And Lundgren himself made no explicit comparison between Sweden’s banking crisis and that of Japan. His was a low-key speech made in the Swedish Embassy, in itself quite a contrast from the hectoring “gaiatsu” that one normally associates with “helpful” advice from the West. So conditioned are the Japanese to high volume public lectures, that this might explain the comparative lack of publicity.
If the scale of the problems were not strictly comparable, there are still many similarities between the two crises. Hence, there are lessons for the Japanese to draw from the Swedish experience. In each case, there was a rapid expansion in the real economy generated by an explosion of credit interacting, on the way up, with an explosion in asset prices of one kind or another. Swedish banks got into trouble when the resultant speculative bubble that inflated during the second half of the 1980s lost its air in the early 1990s. Then property prices collapsed. The markets crashed, overexposed banks headed toward the wall, and the economy was imperiled.
But the Swedes dealt with the resultant banking crisis quickly and with total transparency. There was little attempt to mask the size of the bad debts and an entity was quickly set up, the Bank Support Authority, whose political independence enabled the government to avoid any conflict of interest and thereby secure greater public acceptance for the use of public money. The Authority was quickly able to get to the root of the problem. It divided banks into three categories: long- term profitable with short-term problems; long-term profitable with uncertain capital-adequacy ratios and medium-term problems; basket cases likely to be beyond reconstruction.
These classifications allowed the BSA to decide quite easily how to handle each bank: Some required no more than increased capital contributions from shareholders, some were to be nationalized, and some were to be closed altogether. Troubled loans were transferred to a separate company. In all, the government’s intervention was devised on a commercial basis to minimize the cost to the taxpayer. But taxpayers’ money was required, as a large chunk of the banking system was de facto nationalized, given the government’s unconditional guarantees to bank creditors (which lasted for almost 6 years).
While the global recovery undoubtedly helped to mitigate the extent of the problem loans faced by the Swedish monetary authorities, it is undeniably the case that their prompt, aggressive actions prevented a bad crisis from turning into a total disaster. According to Lundgren, within 6 years the BSA was wound up, nationalized banks were sold back to the private sector, and the total cost of the bailout ended up being around the equivalent of 6 per cent of GDP, half the number originally feared by the Swedish authorities.
Needless to say, the scale of the problem is considerably higher in Japan. But the fact of the matter is with the economy in depression, Japan’s monetary and financial authorities have virtually no good options left, as Bernard Connolly clearly recognizes. In the end, even Mr. Koizumi’s determination to stick to his policy of holding new bond issues to 30 trillion yen annually will likely prove untenable, Mr. Rubin’s reported support for this fiscal restraint notwithstanding. (In fact, it is somewhat inconsistent for Rubin to laud Mr. Koizumi’s self-imposed limit on bond issuance on the one hand in order to prevent interest rates from rising excessively if the target is dropped, yet on the other hand, to propose a policy of inflation targeting, the ultimate consequence of which would almost surely be the same as renewed fiscal profligacy – namely, sharply rising bond yields.) The government must choose the least bad alternative, and that is to reflate, either proactively or reactively, to reduce the rising burden of debt that is being compounded by prolonged heavy government borrowing and by accelerating deflation. The alternative, to do nothing, simply ensures that the problem will get worse and the pain caused by a transition from deflation to reflation will be even greater.
Commenting on the “Swedish solution”, Brian Waterhouse identified eight keystones which ensured its success: 1. Early recognition of a crisis. 2. Acknowledgment that action is pressing. 3. Unconditional official support for the banking system. 4. Political leadership and unified public opinion. 5. Intervening legislation. 6. Independent supervision of the reconstruction process. 7. Nationalization if necessary. 8. Determination to denationalize as soon as possible.
There is an additional factor unmentioned by Waterhouse. Sweden had proper functioning, politically legitimate institutions, thereby enabling the government to mobilize public opinion and deal with the problem from a position of responsible and accountable public leadership. Mr. Lundgren himself noted that the job was basically achieved with a core committee of just three Cabinet ministers, a total of six senior government officials regularly involved, and the use of two independent consulting firms, rather than the usual morass of backroom committees and bureaucrats, which constitute the essence of the Japanese polity. In other words, Sweden had something approaching true democracy. We have often made the point that politically responsive institutions are totally lacking in Japan, and that the resultant policy paralysis brought about by 50 years of corrupt LDP leadership (and Washington’s continued patronage) has exerted a huge economic and social cost. The messy resolution of the country’s long-standing financial crisis, when it comes, will probably constitute the most vivid illustration of this point.
US calls on Sweden’s “Mr Fix It” Bo Lundgren – Telegraph