By Alan White
From 1992 to 1998, Japan’s economy drifted in what became known as the Heisei depression, as banks and regulators stubbornly refused to recognize losses on overvalued loan and real estate assets. The prolonged crisis in Japan had been preceded by a bubble in real estate and stock prices, leading to a huge debt overhang based on inflated values. Sound familiar?
The consensus among policy economists is that Japan engaged in “regulatory forbearance” for far too long after the 1980’s bubble burst, allowing insolvent banks to limp along in the vain hope that nonperforming loans and property values would someday return to levels needed to right their balance sheets. By stubbornly refusing to write down assets (outstanding loans and book value of real estate owned) and to liquidate insolvent banks, Japanese policy makers significantly increased the macroeconomic costs of a prolonged recession and inevitable revaluation.
Thus far, the Administration’s approach to the subprime mortgage crisis shows an unfortunate resemblance to the Bank of Japan strategy of the 1990s. Treasury has exhorted mortgage holders to voluntarily restructure defaulted loans, but has rejected all proposals for either mandatory debt write-downs or government bail-outs, as exemplified by the Resolution Trust Corporation’s takeover of bad loans and foreclosed properties after the savings and loan crisis. Meanwhile mortgage servicers, acting more or less on behalf of investors, have rejiggered interest terms but have largely refused to write down even a dollar of principal on the underlying subprime mortgages.
The number of mortgages that exceed the market value of the home, now estimated at 12 million, continues to mount. The debt overhang can be eliminated only in three ways. Massive foreclosures and distressed sales would do it, but all evidence is that the foreclosure process is getting bogged down and this resolution will take years. Voluntary or mandatory write-downs of mortgage balances would also do the trick. Alternatively, some sort of government intervention, either by taking over mortgages and restructuring them, or insuring replacement mortgages, could speed the deleveraging process.
My friend and colleague Anna Gelpern, whose excellent forthcoming work got me thinking about comparisons to previous international debt crises, directed me to a very interesting paper on another historical analogy to the current crisis. In 1933 Congress and the Roosevelt administration abrogated all clauses in existing debt contracts requiring repayment in gold (i.e. protecting lenders from dollar inflation), and by doing so effectively wrote down existing obligations of debtors by 69%. The paper in question argues that this massive debt jubilee, while transferring income from creditors to debtors in the short run, benefitted everyone, including creditors, in the long run, by eliminating the debt overhang and the huge costs that a wave of bankruptcies would have imposed on the economy. The paper concludes that in a debt crisis, it is better to forgive than to receive. The paper’s author? Current Federal Reserve Board Governor Randall Kroszner.
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