Across the world, governments and central banks are desperately trying to unblock the frozen credit markets. Through a combination of re-capitalisation, state-guaranteed loans and quantitative easing, the hope is to inject more money into an illiquid banking sector, drive down real interest rates and thus restore the flow of capital to cash-starved businesses and struggling homeowners.

But none of this activism will work unless and until policymakers address the problem of excessive corporate and private debt that caused this crisis in the first place. In fact, the constant firefighting is blinding governments and central banks to the adverse long-term effects of ill conceived, short-term measures like costly, no-strings bank bail-outs. What is required instead is large-scale debt conversion.

The problem of debt will get much worse before it gets better. Banks and other financial institutions are bracing themselves for another wave of debt defaults – this time not from dodgy mortgage schemes but from commercial real estate, credit cards, car and student loans, corporate bonds, insurance and pension funds. Only last week, the IMF raised its estimate of financial sector write-downs from its October 2008 forecast of $1,400bn to a staggering $2,200bn. According to Nouriel Roubini, the economist dubbed "Dr Doom" for his gloomy predictions three years ago (which turned out to be broadly accurate), total US financial losses from the credit crunch could reach as much as $3,600bn, compared with a capital base of $1,400bn. In that case, says Roubini: "the financial system is insolvent. It's technically bankrupt."

Lower real interests alone won't do the trick because in a falling market, banks have few incentives to lend and every reason to hoard the public money that was injected as part of the double re-capitalisation in September 2008 and last month. Why? Because the ongoing fall in the value of assets increases liabilities, forcing further sell-offs and putting more pressure on assets – a vicious cycle of debt-deflation. Lending will only be restored to adequate levels if and when unsustainable debt is restructured, more demand for goods and services is generated (making investments once more profitable) and, yes, real interest rates are lowered.

If the full flow of credit is to be restored in these conditions of debt-deflation, then governments and central banks must now enact bolder measures than acquiring equity shares that are impossible to value, or buying up the toxic assets that undermine trust in the international financial sector.

One radical policy is debt conversion, whereby mortgages and consumer credit are converted into long-term, low and fixed-interest loans. Governments should urgently consider proposals by the Harvard economist Martin Feldstein. He has suggested that the state offer mortgage holders the option of replacing a share of mortgage (20-50%) with a low-interest loan from the government, subject to a maximum amount.

...This sort of state assistance should be made available not just to individual borrowers but also to housing associations, especially those that have formed joint ventures with building companies and are now facing an acute funding shortage. Similar debt conversion programmes could be extended to other sectors that are crippled by debt, including commercial real estate and consumer loans.

One key advantage of debt conversion is that it deals with the immediate debt burden while reducing private and corporate bankruptcy and also avoiding the need for total debt cancellation, both of which would further depress assets. By interrupting the vicious circle of debt-deflation, debt conversion helps establish a floor to asset prices...

posted by speakingcorpse : 2/06/2009 03:11:00 AM