Wednesday, April 2, 2008

Could an economic lesson from Sweden work in the U.S.?

By David J. Lynch, USA TODAY
As U.S. officials hunt for solutions to what many economists are calling the most serious financial crisis since the Depression, they might draw lessons from another painful and costly banking emergency.
In the early 1990s, a massive Swedish real estate bubble burst, littering the Nordic economy with broken finance companies, failing businesses and jobless workers. It was the first systemic banking crisis in an industrialized country since the 1930s and it saw the Swedish economy actually shrink for three straight years — something that hasn't happened in the United States since the rapid demobilization after World War II.

The Swedish and American crises share many traits: Both followed periods of financial deregulation, and both featured newly daring banks relying upon bookkeeping maneuvers to take on unsustainable amounts of debt. Happily, despite economic conditions that were far worse than in the USA today — and unlike a similar episode in Japan — Sweden quickly recovered.

Yet, it did so in a manner that would be highly controversial in the United States. Sweden used taxpayer money — and lots of it — to rebuild its wounded banks. "In Sweden's case, the solution ultimately ended up on the government's balance sheet. … The government ended up recapitalizing the system," says economist David Rosenberg of Merrill Lynch. "There's a lesson here."

Sweden's successful crisis management may offer a road map for U.S. officials. But the Swedish cleanup wasn't cheap. It cost the public an estimated 6% of annual economic output; an equivalent bill for the U.S. today would be nearly $850 billion. And Sweden was able to implement a free-spending government rescue only because of a broad political consensus that is difficult to imagine amid the hyper-partisan atmosphere of a U.S. presidential election year.

"There was a tradition in Sweden of cooperation across party lines. … It was such an obvious crisis, everyone was really frightened," says Peter Englund of the Stockholm School of Economics.

A familiar story

To anyone who's been paying attention to deteriorating financial conditions in the USA, the Swedish episode seems eerily familiar. First, there was the multiyear expansion, with incomes surging and good times appearing all-but-permanent.

Amid the boom, however, seeds of future trouble were sown in Sweden. A comprehensive deregulation of the credit markets in 1985 introduced bankers to new customers, products and markets that neither they nor their government regulators fully understood. "The supervisory authority was not prepared for the new environment that emerged after credit market deregulation. This meant that during the 1980s the banks were able to grant loans on doubtful and sometimes even directly unsound grounds without any supervisory intervention," wrote Urban Backstrom, at the time a senior Finance Ministry official.

Much of the avalanche of new borrowing poured into an overheated property market, where prices for commercial real estate more than doubled in the latter half of the 1980s. The first signs of trouble appeared among the finance companies that were responsible for the bulk of such investment. In September 1990, a company called Nyckeln — known as "The Key" — folded when it was unable to renew its financing.

Many of the finance companies were owned by the handful of major banks that dominated Sweden's economy. Companies like Nyckeln financed their operations with a new type of commercial paper called marknadsbevis (marknads-BAY-vees) which the banks had guaranteed. When Nyckeln defaulted, the market for these securities suddenly collapsed and the losses ricocheted back onto the banks' balance sheets, much as U.S. banks today have been hurt by losses from complex securities they held off their balance sheets.

"There's a striking similarity with what is happening now," says Staffan Viotti, senior adviser to the head of Sweden's central bank.

By late 1991 there were indications that two of Sweden's major banks had exhausted their capital reserves and were barreling toward bankruptcy. Property prices, which once seemed capable only of rising, plunged by 50% in 18 months.

The economy shrank in 1991 for the first time in 10 years, then continued shrinking in 1992 and 1993. Unemployment took a sudden leap from 1.6% in 1990 to as high as 12% in 1993. Government officials debating their response met in "an atmosphere of national emergency of an almost war-like kind," according to Viotti.

Fearing that a collapse of the banking sector would capsize the economy, the Swedish government in September 1992 issued a blanket guarantee of all of the banks' obligations. Depositors, lenders and trading partners would be protected from loss. But to avoid encouraging financially risky behavior in the future, shareholders were made to suffer. In return for public money, the government received equity in the banks while the existing owners saw their stakes reduced.

Swedish lawmakers created an independent agency — the Bank Support Authority — to preside over the rehabilitation of the battered banking sector and gave the agency a blank check. But any bank that sought government help had to submit to a detailed assessment of each of its loans. In practice, that meant a government-organized process of financial triage, separating the healthy parts of the banking industry from those that were rotten.

The "good" parts of the industry were saved with injections of fresh capital from both government and private sources. The "bad" parts were placed with two government-created asset-management companies and sold off. One major bank, Gota Bank, went bankrupt and was merged into the healthy Nordbanken in 1993 (today known as Nordea).

"One of the most important lessons is that authorities must be able to intervene as quickly as possible when a bank faces problems," Stefan Ingves, the architect of the rescue operation and the current head of the Riksbank, Sweden's central bank, later wrote.

Pennies on the dollar

The government's decisive handling of the situation led to an economic recovery almost as sudden as the crisis that preceded it. The economy expanded at an annual rate of nearly 4% in both 1994 and 1995. The emergency bank guarantee was eliminated in 1996 and replaced with a deposit insurance system akin to the Federal Deposit Insurance Corp. in the USA.

Sweden's sure-handed resolution of the crisis won applause from economists, including then-chairman of the Federal Reserve Alan Greenspan, who said in 1999 that the episode showed that "speedy resolution is good." The IMF drew on the Swedish case in preparing a list of "best practices" for Asian countries trying to survive their own crises in the late 1990s.

Today, Treasury Department spokeswoman Brookly McLaughlin says officials are aware of the Swedish experience but do not consider it "an example for us."

There are differences between the Swedish and U.S. situations, which some say argue for caution. Sweden, after all, is a small country. Its annual economic output is equal to about 10 days' worth of activity in the USA. Sweden's troubles also were exacerbated by provisions of its tax system and an ill-advised defense of a fixed exchange rate. That led authorities, amid a general European currency crisis in late 1992, to briefly increase overnight interest rates to a commerce-killing 500%.

Today's U.S. financial woes also are unprecedented in their complexity. The current crisis isn't limited to the commercial banks and traditional lending practices. Instead, investment banks and a host of securities that didn't even exist in the early 1990s — such as credit default swaps, collateralized debt obligations and structured investment vehicles — play starring roles today.

"It was much easier in those days as an outsider to assess the financial situation of a specific bank," says Goran Lind, a senior Riksbank official. "Today, things are a lot more opaque."

Still, some see indications that the U.S. already is applying lessons learned from Sweden. Anders Aslund, a Swedish economist at the Peterson Institute for International Economics in Washington, D.C., points to the swift sale of the troubled Bear Stearns investment bank to JPMorgan Chase as a key example. The deal, midwived by the Federal Reserve, avoided the danger that a collapse of Bear Stearns would topple additional financial institutions. And it left shareholders with pennies on each dollar of their investment.

Paying the price

"Bear Stearns looks, to my mind, exactly out of the book how Sweden handled the banking crisis," he says.

Edward Kane, a Boston College finance professor, says the Fed's decision to facilitate the sale by backing $29 billion worth of Bear Stearns' assets is the first sign of what amounts to a government takeover of the financial system. "They've implicitly provided guarantees to any number of these firms. There is a nationalization (occurring). It is implicit and unacknowledged," says Kane, who has consulted for the Fed, the International Monetary Fund and foreign central banks.

Such a guarantee makes the government a part-owner of the country's major financial institutions. In Sweden, for example, at the height of the crisis, the government held 22% of the banking system. When the crisis eased and banks returned to profitability, the Swedish taxpayer shared in the gains.

Kane says the U.S. government should embrace the Swedish remedy and issue a formal guarantee of the country's financial institutions, so that taxpayers can benefit from any rebound. "To get the upside, we have to make it explicit. … The public is owed a better description of what's going on than they're getting," he says.

Swedish officials, such as Lind, say the government ultimately recovered all of the money it spent to recapitalize the banks through sales of the non-performing assets. The World Bank's definitive "Banking Crisis Database," however, puts the net cost at a still high 4% of gross domestic product.

Even as the economy regained momentum, Sweden continued to pay for its earlier profligacy. Unemployment remained above pre-crisis levels throughout the 1990s and the Swedish government, which had run a surplus in the 1980s, suffered budget deficits for seven consecutive years. Swedes' relative living standards also took a hit.

Sweden ranked third in per-capita income among the 30-nation Organization for Economic Co-operation and Development in 1970 behind only the USA and Switzerland. By 1991, it had fallen to 14th, where it ranks today.

Harvard University professor Kenneth Rogoff, co-author of a recent study of modern financial crises, says the cost of fixing the troubled U.S. financial system will be at least as much as Sweden spent. And maybe more.

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