Stop burying your head in the sand – write off bad debts

Over the weekend European finance ministers extended another £11 billion of “aid” to embattled Greece. Given that default looks highly likely if not inevitable, Europe can only be burying their heads in the sand with this “extend and pretend” strategy of continually extending finance to Greece under the pretence that they will be able to fix their economy.

Martin Wolf at the FT provides a compelling argument for the inevitability of a Greek default. And the markets appear to concur if we consider that the spread between Greek and German 10-year bonds has continued to grow in recent months. Even the latest French proposal for the rescheduling of Greece’s debt repayments is probably a form of default according to Standard and Poors.

So why is the ECB and the rest of Europe pouring money into an ostensibly sinking ship?

Looking at data available from The Guardian, German, French and Belgian banks together own approximately a quarter of the £91 billion Greek debt, while British banks (RBS, HCBC and Barclays) hold a further £2.3 billion. Propping up the Greek economy therefore buys the private sector time to transfer some of this debt to the public sector or to otherwise write down some of the debt.

The practice of socialization of bad loans that occurred during the financial crisis and which is happening again now may increase the stability of the financial system in the short term, but will lead to long term instability as banks learn that their governments will insulate them from their most risky endeavours. This is called a moral hazard.

There appears to be evidence that governments aren’t the only ones rolling over bad loans and propping up failing enterprises. The inaugural meeting of the Bank of England’s financial policy committee hinted that banks may be extending loans they know can’t be fully repaid e.g. where a property is worth less than the mortgage secured on it.

While The Observer appears to believe banks are doing this benevolently because the human and social cost of repossession is enormous”, my view is that they are doing it to keep their own balance sheets looking healthy.

This practice of extending and pretending – continually rolling over bad loads rather than forcing the debtor into bankruptcy – leads to a misallocation of resources and ultimately undermines economic growth. Often called “evergreening”, it is blamed by some economists for the stagnation of the Japanese economy in the 1990’s where healthy firms were starved of credit in favour of propping up ailing businesses to protect the bank’s own balance sheets.

Thus in order to stave of a Japanese-style “lost decade” we need to let the patently unhealthy wither and die, whether that be households, firms, banks or even countries. This view is supported by the Bank of International Settlement’s annual report, which argues that banks should be forced to write-down bad loans and that governments should ensure that they have enough capital to sustain such losses.

So, the Government needs to take its own advice and let the market do its job. Let the highly indebted go to the wall and force creditors to feel the cost of their actions. Give healthy sectors of the economy the finance they need to grow. And in all likelihood these sectors wont be construction and finance that fuelled the last boom, so the Government should look elsewhere. But that’s a post for another day.

1 comment for “Stop burying your head in the sand – write off bad debts

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