The lead story at the New York Times last week, "Toxic Loans Around the World Weigh on Global Growth" by Peter Eavis, gives a one-sided view of the problem of too many bad loans around the world that have yet to be recognized and resolved. It's an economically warped account that leaves important policy options off the table.
The big tell is that the article has nary a mention of the idea of restructuring loans, which is the time-honored way that banks deal with problem loans. A former McKinsey partner who was in charge of workouts at General Electric, which had a huge financial services arm and a boatload of drecky debt in the early 1990s, named one of his conference rooms "Triage" and the other "Don Quixote." And in some sense, that illustrates the poles of how to deal with an underwater borrower: see if they can survive or not, and deal with them accordingly, or engage in various "extend and pretend" strategies. Another bankers' saying is "A rolling loan gathers no loss," meaning you can keep making a hopeless borrower look viable, sort of like propping up a corpse and putting enough perfume on it to hide the stink, by giving new loans so they can keep paying interest (see Greece as a textbook case).
Workouts? What Workouts?
Here is the first discussion of "what to do about the problem," starting well into the article, at paragraph nine:
In theory, it makes sense for banks to swiftly recognize the losses embedded in bad loans - and then make up for those losses by raising fresh capital. The cleaned-up banks are more likely to start lending again - and thus play their part in fueling the recovery.
But in reality, this approach can be difficult to carry out. Recognizing losses on bad loans can mean pushing corporate borrowers into bankruptcy and households into foreclosure. Such disruption can send a chill through the economy, require unpopular taxpayer bailouts and have painful social consequences. And in some cases, the banks might find it extremely difficult to raise fresh capital in the markets.
First, it always makes sense to recognize the losses. They exist. The Japanese, at the very early stages of the US financial crisis, gave an uncharacteristically blunt warning that their big mistake and the reason they were then mired in a lost decade-plus, was failing to clean up their bad bank loans.
Second, and more important, there's no mention of the idea of debt restructuring, of the bank taking half a loaf and moving on. Notice how the only options depicted are corporate bankruptcies (which outside the US are generally liquidations, and this story focuses almost entirely on foreign debt) and foreclosures. While banks have the legal right to pursue these options, if the borrower has a decent level of income, a restructuring is almost always the better course of action. Not only are the outcomes typically better for the lender, they are also better for the borrower, and thus reduces the economic costs to both parties. This is one reason why the US policy during our mortgage crisis was disgraceful and short-sighted. The government had the power to force banks and mortgage servicers to undertake outside the box solutions, because mortgage lender had made such a mess of how they had handled mortgage documentation that in many, arguably most cases, they did not have the right to foreclose. The government thus held the whip hand: if it let the mortgage chain of title mess continue to metastasize, it would eventually brig down the mortgage industrial complex. The banks needed official help in a very large way.
But the Administration went all in for papering over that problem, giving the banks what amounted to a second bailout by letting them out of institution-destroying liability on the cheap, and not insisting that they work out mortgages (in particularly, give principal writedowns).
Third, and we'll turn to this in more detail soon, the article leading up to this point makes lending sound as if it is a primary driver of "recovery" (the "play its part" language is weaker than the depiction in the preceding paragrpahs). We'll debunk that idea.
In other words, that extract, and indeed, almost the entire article, gives the impression that the only options with a debt overhang are forcing borrowers into penury or bank bailouts. Only in the third to the last paragraph do we get a passing mention of other possibilities:
In some cases, the delay arose from a reluctance, at least in part, to force people out of their homes. Even though Ireland's biggest banks suffered huge losses after the financial crisis, they held back from forcing many borrowers who had defaulted out of their homes. In recent years, the Irish government has pursued a widespread plan that aims to reduce the debt load of financially stressed homeowners. Such forbearance appears not to have weakened the Irish economy, which has recovered at a faster rate than those of other European countries.
Recall that Ireland has the most outsized real estate bubble, with private credit at a staggering 12X GDP. Eavis almost seems puzzled that Ireland did better than other countries by restructuring debt, which he describes using the atypical term "forbearance," which is more commonly used to describe when regulators let their charges get away with breaking rules. (There are other reasons Ireland "recovered" more quickly that are not pretty, and not open to other countries, like large scale emigration).
And there's no mention of Iceland, which had a staggeringly large debt bubble, and was forced into recognizing the losses immediately due to the collapse of its central bank. Iceland prosecuted its bankers and cleaned up its banks, not just the loans but also the boards and top leadership. Even though its degree of recovery is often overstated in the media, it's still done very well given the severity of the underlying problem.
No, Virginia, Banks Do Not Drive Growth
Another big problem with the subtext of the story is that it depicts the problem of excessive debt being a problem for growth primarily due to its impact on bank lending, by reducing their capacity to make new loans. The article does mention in passing how companies and borrowers struggle under heavy debt loads. But it fails to translate this into macroeconomic effects, which has been set forth clearly by economist Richard Koo in his description of "balance sheet recessions."
When businesses and individuals are overburdened by borrowings, they prioritize paying down their obligations over other spending, even if that "spending" might be an investment that would put them ahead overall. They recognize that their debt servicing levels have made them vulnerable to other shocks, so getting their borrowings down to a more viable level amounts to risk reduction. But thus sensible behavior on an economy-wide basis dampens growth.
We can see a classic example of how this works in the US with student debt. Enough young people are burdened with student loans to such a degree that it is underminimg their ability to leave home, get married and start families, and buy homes. That in turn has dampened the increase of the housing supply, and led it to be more in lower cost, typically rental "multifamily" buildings, meaning apartments, rather than houses. Housing has traditionally been the driver of US growth cycles; the weak housing recovery is one of the reasons the current growth path is so anemic.
So the real story of why debt hangovers hurt growth operates mainly through the demand side: corporations and individuals that are belt-tightening, or worse, faced with catastrophic failure, rein in their spending. But that's not what you hear from the Times:
Bad debts have been a drag on economic activity ever since the financial crisis of 2008, but in recent months, the threat posed by an overhang of bad loans appears to be rising. China is the biggest source of worry. Some analysts estimate that China's troubled credit could exceed $5 trillion, a staggering number that is equivalent to half the size of the country's annual economic output.
Official figures show that Chinese banks pulled back on their lending in December. If such trends persist, China's economy, the second-largest in the world behind the United States', may then slow even more than it has, further harming the many countries that have for years relied on China for their growth….
In Europe, analysts say bad loans total more than $1 trillion. Many large European banks are still burdened with defaulted loans, complicating policy makers' efforts to revive the Continent's economy. Italy, for instance, announced a plan last week to clean out bad loans from its plodding banking industry.
Elsewhere, bad loans are on the rise at Brazil's biggest banks, as the country grapples with the effects of an enormous credit binge.
In all of this, you see an focus on the symptoms - banks with high levels of debt - rather than the diseases. In China, for instance, it has been a government committed to growth levels that it sees as necessary to maintain the legitimacy of the officialdom, but are no longer viable under China's investment and export-driven growth model. Investment has hit 50% of GDP, a level that is unsustainable. On an economy of China's scale, large economic losses were inevitable. Because this investment binge was debt funded, that means big losses to lenders (which are not just banks but include participants in China's large shadow banking system).
This paragraph epitomizes the misguided position of the article:
In good times, companies and people take on new loans, often at low interest rates, to buy goods and services. When economies slow, these debts become difficult to pay for many borrowers. And the bigger the boom, the more soured debt that is left behind for bankers and policy makers to deal with.
First, this section makes consumer borrowing sound virtuous. For the most part, it isn't. Academic studies have repeatedly found that household debt levels are negatively correlated with economic growth. In other words, this depiction of individuals borrowing to fund consumption is the neoliberal model that has been in place in the US since the early 1980s: of having consumers rely on borrowing to achieve rising standards of living rather than wage growth. We hit the limits of that approach with the 2008 crisis.
Second, as we've said repeatedly, businessmen do not borrow and invest because money is on sale. They borrow and invest because they see a business opportunity. They are more likely to see opportunities when the economy is strong than when it is crappy. The availability of credit can thus constrain business growth, but cheap money alone won't do much to promote it.
The one exception to that story is businesses where the cost of money is their biggest, or one of their biggest costs. What businesses are like that? Financial speculation or the purchase and sale of highly levered assets, like real estate. So it should not be surprising that low interest rates have goosed asset prices rather than stimulate real economy growth. The Fed was not so totally clueless as to not understand that. But it convinced itself that rising stock and housing prices would lead to a wealth effect, that would in turn lead to more spending. But since wealth in concentrated in the upper income strata, that at best amounted to trickle down economics. That has never been very successful, as recent results confirm.
And What About Policy Options?
The article fails to acknowledge that Europe's continuing banking mess is due in large degree to the fact it has no satisfactory mechanism for bank resolution, and its banking union is flawed and incomplete to a degree that it if anything increases the odds of financial crises (more on this in the next few days). And this part is troubling:
Wherever governments and central banks unleashed aggressive stimulus policies in recent years, a toxic debt hangover has followed
It treat "stimulus" as if it were all of a muchness, and in the context of this story, where there is nary a mention of fiscal stimulus. The only references in the story are to cheap lending. That leaves readers with the impression that the sole medicine is ineffective, even counterproductive monetary stimulus.
While we are glad to have the Times confirm a point we have been making for years, that monetary pump-priming was not going to help, and would at most boost bank profits without doing much for the real economy, it's disturbing to see this article put on neoliberal blinders and not even admit that deficit spending is an option, and actually would have been a vastly better course of action than the cheap-money approaches taken. The best course of action, as we stressed during the crisis, would have been to nationalize the sickest banks, push banks across the board to restructure loans, recapitalize banks as needed (with new boards and executives put in place) and have aggressive deficit spending offset the downdraft from working out the loans.
But again, in our neoliberal, and therefore Panglossian best of all possible worlds, deficit spending is a dirty word. The Times, whether by accident or design gives a very clear account of the cost of global malaise that has resulted from failing to deal with the debt crisis head on and bring the best tools to bear on it.