Some lessons on overindebtedness

In an article in the FT, Martin Wolf argues (based on a speech by Ben Broadbent, a member of the Bank of England’s Monetary Policy Committee) that the main problem with indebtedness is not its extent but the quality of debtors, their ability to service their debt. In dealing with a debt problem, the lessons from Scandinavia offer important insights, see as explained by the MacKinsey Global Institute :

- Both Sweden and Finland endured credit bubbles and collapses in the 1990s, followed by recession, debt reduction, and eventually a return to robust economic growth. Their experiences and other historical examples show two distinct phases of deleveraging. In the first phase, lasting several years, households, corporations, and financial institutions reduce debt significantly. While this happens, economic growth is negative or minimal and government debt rises. In the second phase of deleveraging, GDP growth rebounds and then government debt is gradually reduced over many years.

- The historic deleveraging episodes reveal six critical markers of progress: the financial sector is stabilized and lending is rising; structural reforms unleash private-sector growth; credible medium-term public deficit reduction plans are in place; exports are growing; private investment has resumed; and the housing market is stabilized and residential construction revives.

An enlightening example is how Sweden handled their housing loan crisis in 1993: the state undertook a lot of costs and risks and acted swiftly:

- generally guaranteed all liabilities of the Swedish banks except those of the shareholders (this was important to avoid moral hazard);

- special agencies took over the bad loans and sold off property which had to be seized from non-performing borrowers - banks were treated differently (in three categories) according to the magnitude of their problem;

- the central bank provided liquidity to the banks;

- all actions were taken and explained publicly;

- The Swedish Krona was devalued.

This cost about 4% of Swedish GDP according to Wikipedia (Its summary is simple but not bad). But the state required its price:

- the banks had to write down losses and issue shares to the Swedish state; - the profits from selling the seized property benefited taxpayers;

- also, the shares in the banks were sold at a profit for the state when the banks were again trading profitably; - a supervisory agency was formed, separately from the one which took over bad debt and sold the property.

The estimates of the benefits vary and some (among them some big Swedish banks) criticize the solutions chosen, partially because in their opinion the state went too far and partially as no measures were taken to prevent the crisis from repeating. In fact, however, Swedish exports spectacularly rose in the 15 years following the crisis. The EU study referred to below states that all costs were recovered. some others think it was only the half. One more factor: An article from 1994 highlights an interesting phenomenon: while in the U.S. homeowners normally default if the value of their property falls below their outstanding debt, this is much more seldom in Sweden. A lot of material is available about this. Let me highlight a European Commission study first. The latest account with comments, based on a lecture by Urban Backström, president of the Swedish central bank (Riksbank). Bäckström States: "Thus it was important both to avoid a widespread failure of Swedish banks and to bring about a macroeconomic stabilisation. The two are interdependent. The collapse of much of the banking system would aggravate the macroeconomic weaknesses, just as failure to stabilise the economy would accentuate the banking crisis." And his conclusion is: "This is an immense task that the Swedes took on. Their entire banking system was effectively insolvent. Yet, they were able to fashion a workout scheme that had bi-partisan political support, did not unfairly reward shareholders, dealt with moral hazard, separated regulatory and workout roles so as to reduce conflicts of interest, and that quickly wrote down valuations and liquidated the bad debts as opposed to dragging the process out. The Swedish authorities should be especially commended for dealing with the liquidity and solvency concerns simultaneously, while keeping moral hazard to a minimum."