I’m afraid I’m getting old, grumpy and cynical about the role of banks in the US/Europe. My latest in the Age this morning follows. If you’re interested in the failed Buffet bailout of LTCM you can find more in Nicholas Dunbar’s book, Inventing Money. It is a complicated story, cut consistent with my view that the Fed and US Treasury have been captured by financial markets – which is why it is a bad idea to have ex-Goldman Sachs execs running the Treasury…

Will Greece default and lead us to GFC2, as many alarmists seem to be predicting? Well if it does, bring it on. GFC1 is unfinished business, and needs to be finished before economies in Europe and the United States properly recover. Supposedly the great risk facing financial markets currently is that a default in Greece will bring down banks across Europe and potentially elsewhere, leading to the sort of chaos that we observed after the failure of Lehman Brothers in 2008. [DDET Read more]

What we learned from Lehman Brothers collapse was that financial markets are interconnected. We learned that in many countries financial institutions were undercapitalised and lacked liquidity. Financial institutions also held many toxic assets. What we seem not to have learned from the GFC is that financial institutions sometimes need to fail.

Unfortunately financial sectors too often run into trouble. Recent experience in Japan and Korea provides important lessons in how and how not to handle financial crises. In 1990 Japan’s banks and corporate started to suffer losses due to falling equity and real estate prices. The Japanese government dithered in the face of balance sheet problems at Banks and major corporates, and Japan entered more than a decade of recession and weak economic growth. Banks were not properly restructured until the middle of last decade, by which time Japan had endured 15 years of slow economic growth.

Korea’s banks and corporates suffered greatly during the Asian financial crisis. Balance sheets were decimated by currency mismatches – short term US dollar denominated borrowings became toxic when the exchange rate fell by 50 percent at the end of 1997. But the Korean government faced up to problems in the financial sector. Two rounds of financial restructuring at the beginning of 1998 and during 2000 led to the closure of 11 of Korea’s 36 banks along with several hundred smaller financial intermediaries. The government recapitalised or nationalised some financial institutions, encouraged mergers or revoked licenses in the financial sector. The result of this painful restructuring was a rapidly recovering economy, with GDP growth in double digits in 1999 and continuing to be strong until the GFC hit Korea’s export markets in late 2008.

The lessons from Japan and Korea are clear. Restructure financial systems slowly and endure drawn out pain. Or take the pain in one hit, restore balance sheets, and then enjoy recovery. Alas the lessons from the United States and Europe is that pain of the drawn out kind is preferred, with the pain felt by the broader society and economy rather than financial markets whenever possible. In the aftermath of the Asian crisis in 1998 a large US hedge fund, Long Term Capital Management, was near failure due to bets on Russian junk bonds. Warren Buffett offered to buy LTCM, intending to sack its managers and restructure. Instead the Fed engineered a bailout of LTCM at more attractive terms to LTCM shareholders and without sacking its managers. The Fed’s justification was fear of contagion across the interconnected US financial system. And again after the 2008 failure of Lehman’s the Fed and the US Treasury failed to force pain on US financial institutions, preferring bailouts to restructuring.

It is not surprising that the IMF, the EU and governments in Germany and France prefer to see Greek citizens face the pain of an impossible austerity pain, deferring financial market problems to a later day, and preferably passing this pain along to Greek, Irish and Portuguese citizens. But that does not make this policy right. Greece needs to restructure. It is quite possible that such a restructure will lead to further restructuring of public debt in other European countries. And it is quite possible that such restructuring will bring down banks in Europe. So what? Should we instead continue to be held hostage to the possibility that financial institutions in Western Europe might drown in the foolishness of their Greek loans? And if other global banks get entangled in such a mess then it is better to know and solve such a problem than to presume that such a problem exists and that it will be fatal should it occur (it will not be). If we are not to see a recurring cycle of banks holding economies hostage through their holdings of toxic assets we must be willing to see these toxins causing an occasional financial market fatality.[/DDET]

2 Responses to "Hostage"
  1. Mark 
    Don’t you think that the austerity measures that are being forced on Greece have some merit in their own right.  The Greek Government has to cut spending, collect more taxes and reduce the entitlements it has promised its citizens.  
    Until they default they have the ECB and the Germany and France to blame for the pain they are experiencing.  After a default Greeks have to blame each other for their profligacy and reform comes to an end.

  2. Absolutely. Even after default Greece is in deep do-do, and i wouldn’t bet on them reforming enough to solve their problems. But default is inevitable, so what is the point of postponing that. It depends whether you see the default as the start of a long process of reform (which I hope is the case) or just a pure cop out. I guess the other interesting question is whether countries like Greece can be trusted to maintain fiscal discipline long enough not to create ongoing problems for other members of the currency union. A warning not to let the Kiwis adopt the $A?

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