Most of the economic problems in the developed world are due to high levels of private debt that purchased overpriced speculative assets. Many will add their own spin to blame somebody for it (governments, central banks, banks, lazy people, greedy people, etc.). If blame were a solution then our economies would have long ago recovered.
There are several common reactions to a debt crisis:
- Lower interest rate and/or extend term.
- Forgive the borrowers.
- Liquidate the borrowers.
- Lend the creditors money from the government and/or central bank.
The traditional workout is the rate/term. Because of the fear of moral hazard there is a maddening amount of bureacracy and time to make sure the borrower really deserves/needs it. If the rate reductions do occur, they are often just enough to delay the default rather than cure.
The rate/term workout is increasingly forgotten in our politically polarized world, where many want to liquidate in order to punish the debtor, or forgive in order to punish the creditor. The problem with either ideology is that it would not only destroy most banks, but also destroy credit markets and collateral values for decades. For example in the mortgage industry ruthless foreclosures lead to a vicious cycle of falling house prices, more negative equity, and more defaults. And debt forgiveness would make lenders very reluctant to lend in the future.
Since rate/term, liquidation, and forgiveness don't work on a large scale, debt crises soon end up with the delay tactic of lending from the government/central bank/IMF. Swapping one debt for another debt may solve short-term liquidity problems, but it isn't a cure unless the borrower's capacity to pay improves through income growth or collateral appreciation. Unfortunately, neither of those is likely in a balance sheet recession.
A controversial fourth way would be for the central bank to purchase bad debt after it has followed a stipulated restructuring. The restructuring itself would be traditional, the novel part is for the central bank to commit to purchase the restructured debt as a commodity. This gets quantitative easing directed to the heart of the solvency debt problem, rather than pushing more liquidity into excess bank reserves (which are at the central bank rather than flowing through the economy).
Eligible debt would be defined as debt that the market will not refinance (or requires an excessive premium to do so). The central bank would set restructuring policies that place costs on both the lender and borrower (contrary to popular opinion, both are often to blame for bad loans). Restructuring rules would generally be:
- Interest rate is reduced to the rate for best credit.
- Fixed-rate debt becomes floating rate indexed to 1-month risk free rate.
- Lifetime interest rate ceiling is set to prevent large future rate shock, but borrower bears some interest rate risk (likely when economy recovers).
- Principal reduction is possible, but discouraged.
- For secured debt where the borrower has the capacity to pay (is current), the amortization term is shortened so that they pay down debt and achieve positive equity sooner.
The central bank gets creditors to realize their losses through large interest rate reductions to the borrower, and in return the central bank can directly subsidize a specific portion of those losses by paying up for the restructured assets in order to make the deal work. This quickly cleans up bank balance sheets and borrower income statements so that consumption, lending, and investing can increase at a normal pace.
The central bank would have no recourse to the government or bank that sells the restructured debt, so that the central bank would bear the full credit risk. However credit losses should be small if the restructuring works at a macro and micro sense. This approach could be applied to consumer, commercial, or government debt. Consumer and commercial restructured debt would be securitized for easy sale and administration for central banks.
Such purchases by central banks have many advantages:
- Immediate, large reduction in borrower payments will stimulate consumption.
- Removal of bad assets from balance sheets will increase bank capital and lending.
- Higher consumption and easier credit will increase investment and absorb high savings.
- By the central bank stipulating the restructuring terms it removes lengthy means testing and negotiations between the creditor and debtor.
- Collateral values are supported by reducing liquidations and accelerating amortization.
- By indexing restructured debt to short-term rates, central bank and/or markets can easily constrain consumption if inflation becomes a problem.
On the other hand, there are several possible problems with this proposal:
- Central banks take credit risk, which is scary from a political perspective.
- It could create inflation.
- Moral hazard because banks think they will be bailed out in the future.
None of these objections are unique to this policy. Right now the ECB is holding lots of dubious assets as collateral; they take credit risk but won't admit it. And any policy that is stimulative could create inflation; but in a deflationary environment can't the central bank create money without much inflation? As far as moral hazard, we've amazingly already made government bonds subordinate to senior bank bonds in many situations.
In 2008 I would have thought this proposal was insane, but conventional policies haven't worked in the past 5 years of recession. Huge problems are building in Europe and China. The time for radical intervention is approaching, because what is the point of a healthy central bank at the expense of a destroyed economy?