We must write off bad debt

Europe is riddled with bad debt. In some countries, such as Spain, banking systems are in chaos. In other countries, the government has accumulated sufficient debt that it does not even require a failing banking system to call into question its credit rating. All sorts of mechanisms are being designed to try to hide away these bad debts. Governments are lending to banks; banks are lending to governments; the European Union creates all sorts of new-fangled schemes to lend to both. Everybody is guaranteeing the debts of everybody else, yet there are few genuinely credit-worthy entities around.

Much of this can happen because the European Central Bank can print and lend money at will against the collateral of public and private sector assets of any eurozone member nation. If the ECB had not been able to make loans to the banking system, it is likely that the crisis would have come to a head in one country or another by now. Yet, even Greece limps on. But, even in Britain, which is safely outside the eurozone - strange things are happening in this recession.

Unemployment remains surprisingly static, while productivity declines. Banks are, apparently, sitting on a time-bomb of bad debt; private sector bankruptcies are surprisingly low; and there appears to be a huge degree of mortgage forbearance. Some of this is happening because interest rates are low so that borrowers can continue to service their borrowing. In the 1990s United Kingdom recession, those with big debts were wiped out rapidly. However, we also need to ask whether we are simply putting off the necessary adjustment that should take place after a lending boom.

In many countries - such as Spain, Ireland, Estonia and, to a lesser extent the UK and the United States - there was a classic boom up to 2008. Interest rates were too low, consumption rose and investment was encouraged in all sorts of activities that were not profitable in the long term. In most recessions, there is quite rapid adjustment. Businesses go bankrupt, people lose their jobs and capital is reallocated to uses that are more productive. Then, the economy begins to grow again. Indeed, often there is little permanent damage. The human cost of the Great Depression in the UK was high while it was happening but, within a few years, things were back to normal. The same was true in the early 1990s.

This time, the adjustment does not seem to be happening. We seem to be like a roller-coaster car jammed on the circuit just before we should be taking off and going up. There are many reasons for this apart from the fact that interest rates are so low. Labour markets are too rigid, financial and energy markets are increasingly regulated, taxes are too high, courts are increasingly encouraging forbearance of bad debts and regulators seem to be completely oblivious to the damaging effects of policy uncertainty. But, perhaps the main reason is that the banking system is full of bad debt. Banks cannot write down their loans without becoming insolvent or greatly reducing their capital. When banks are eventually forced to write down their loans, the state is stepping in with just enough capital to keep the show on the road. As such huge amounts of capital are being used to just about keep banks in the black instead of being allocated to new economic activities.

We really do need to start writing-off bad debt and ensuring that those who have underwritten that lending take losses. Shareholders of banks need to be wiped out if necessary. The providers of debt capital need to have their debt written down. There even needs to be mechanisms to ensure that depositors take their share of the pain. The fact is that people have taken on board debt and they are in no position to repay that debt. They should either be forced to repay, using punitive sanctions if appropriate, or the debt should be written off. This would certainly be very painful. Banks might go to the wall and people who have lent to those who cannot repay their debts might lose large sums of money. But this reality has to be recognised or major economies face years in the doldrums.

In fact, several years after others - including the Institute of Economic Affairs - proposed the idea, the EU has made proposals to ensure that banks can fail safely. This is welcome, although the centralisation of regulation at the EU level is a bad idea. Also, there is no point having the legal framework to allow bank failures if there is no political will to allow anybody to suffer losses. But the key point is this. The recovery of the financial system is crucial for the recovery of the economy. However, the financial system cannot allocate capital efficiently to new entrepreneurial ventures if capital is propping up an ailing banking system or propping up ailing governments. Business confidence will also not recover if large parts of the financial landscape - as well as governments - are perceived to be on the verge of insolvency. To have a real recovery, it may well be that we need to recognise bad debt for what it is and business failure for what it is.

This article was originally published by Public Service Europe.

I certainly don't agree that depositors should take any share of the pain. If a person deposits his money in a bank his intention usually is to put it there for safekeeping and without the intention to part with it. Unfortunately, English common law by its own operation, and unjustly, automatically deprives the depositor of his property and converts it into the property of the bank which becomes the debtor of the depositor, while the depositor becomes a creditor of the bank in an equivalent amount. If this operation did not take place, bankers would be guilty of misappropriating other people's money for their own use.
Michael - this is an interesting and controversial point (as you know) about which Jesus Huerta de Soto has strong feelings (similar to yours). I am not an expert but George Selgin argues that English common law describes what was always the intention and practice of a bank. It would be peculiar to make fractional reserve banking illegal (in my view) and if it is not illegal then I don't think that deposits can always be absolutely safe. I think it would be reasonable to have a clear class of deposits that was absolutely safe and alongside that appropriate requirements about what the assets were against these deposits (storage accounts as Andrew Lilico called them).
Agree with professor Booth that passing the hot potato around is not solving the real problem. The debt is there and will not disappear magically. Bail out money to plug the gap creates debt elsewhere. Delaying writing off the debt is actually costing more in the long term. Proposals to let banks fail and protect taxpayers money are the right direction although the market will create better solutions that whatever regulators can come up with. However, I don’t understand how came politicians are so keen on pushing resolution plans for TBTF financial institutions but still have not even considered resolution plans for TBTF governments!
Rather than writing debt off would it not be better to come up with a better insolvency product?
not quite sure what you mean, but if you mean consolidating some of this stuff in securities such as Brady bonds, that is not a bad idea.
No I have an alternative banking system that has three factors that reflect risk rather than the current banking system that has one or two at best. This could be used as a national insolvency product.

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