Mark to market accounting is preferable to any alternative. The Japanese credit crisis lasted for over a decade because they didn't have to value bad loans at realistic prices and so were under less pressure to come clean on the lowered value of the collateral held, or on the solvency of their organisation. So they told everyone that everything was fine because there was no pressure to own up to a failure they could simply deny. The same managers who made the mistakes remained at the helm of the same institutions who were horribly clogging up banking system. And they really did clog up the banking system. Actions spoke far louder than words in revealing how distressed Japanese financial institutions were. They refused to lend any of the liquidity created by the BoJ to anyone other than the government in the form of massive JGB purchases. This cycle led to zero interest rates and, at one point following the tech bust (a staggering 12 years after the banking crisis), 40bp 10y yields! The credit mechanism remained blocked, the velocity of money circulation collapsed as monetary policy became ineffective and the economy slumped into what became known as the lost decade.
To an extent, therefore, the prolonguation of the Japanese crunch was caused by the absence of the discipline imposed by mark to market accounting. It does help though, if there is a functioning market to mark to which is why the TARP will be a huge step in the direction of ultimate stabilisation and unambiguously, therefore, a good thing.
But will it provde the banks with adequate capital? In last week's FT Martin Wolf wrote this:
"The aggregate stock of US debt rose from a mere 163 per cent of gross domestic product in 1980 to 346 per cent in 2007. Just two sectors of the economy were responsible for this massive rise in leverage: households, whose indebtedness jumped from 50 per cent of GDP in 1980 to 71 per cent in 2000 and 100 per cent in 2007; and the financial sector, whose indebtedness jumped from just 21 per cent of GDP in 1980 to 83 per cent in 2000 and 116 per cent in 2007 (see charts). The balance sheets of the financial sector exploded, as did the sector’s notional profitability. But leverage, alas, works both ways.
Since US net international debt was 39 per cent of GDP at the end of 2007, virtually all of this debt is an asset of another domestic entity ... when the gross debt stock is huge and economic conditions difficult, the chances that many entities are bankrupt is high. When people fear mass insolvency, lenders stop lending and the indebted stop spending. "
So probably not. Banks will likely remain undercapitalised. It is possible that the Asian sovereign wealth funds will be able participate in this recapitalisation. But is it likely? They are already heavily underwater with stakes taken too early in the crisis and indeed, in many cases (China) may yet find themselves with domesitic concerns where that capital could be deployed with higher priority before this crisis has run its course. An undercapitalised US banking system will be a vulnerable one, and one which is incapable of lending at anything like the rate the current generations of Americans have been used to.
And this will be democracy in action. As banking crises have shown in the past, when the problem becomes so great that private-sector recapitalisation is impossible, only the government is left. This is the direction in which Europe is headed. The decisiveness of European govenrments is in stark contrast to the cack-handed and reactive handling of crisis by the US authorities. But Europe has no ideological constraint on state intervention in such matters and can therefore act preemptoraly. As the current mess in Congress is showing the world, America's ideological constraint is very real and very binding. Americans will only sanction the steps the Europeans are now being forced into after they've seen the economic consequences of a disfunctional credit mechanism. The outlook for the US is bleak indeed even with the passing of TARP. Failure by the House of Reps tomorrow will all but guarantee a depression ...
... the central banking policy mistake we're currently witnessing won't help either. One of the lessons from the Great Depression, and from Japan's experience with its real estate bust is that monetary policy has to be adjusted quickly and decisively lower. Instead we've had the opposite. The BoE and the ECB have been unimaginative at best in recognising the deflationary effects of this crisis and history will show they kept interest rates too high for too long because they were concerned by late cycle inflation.
But central banks always make this mistake. The larger error has been in allowing monetary conditions to tighten so dramatically. The world is deleveraging. In the US the mortgage market is now largely nationalised. In the UK, where there were ten mortgage lenders last year, there are now seven (and mortgage approvals have fallen 95% YoY). The rest of Europe is catching up and loan books everywhere are being wound down. Reduced credit supply means a higher cost of credit so mortgage rates are significantly higher than last year, as are interest rate costs for business are higher than last year. Central bank cuts would have kept the monetary stance unchanged. Instead, it has been allowed to tighten. This is a policy mistake which will exacerbate the deflationary effects of this crisis.
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