Tuesday, July 10, 2012

561 How debt forgiveness enabled Japan to rise from the ashes of WWII - Richard A. Werner

How debt forgiveness enabled Japan to rise from the ashes of WWII -
Richard A. Werner

(1) Richard Werner cf Stephen Zarlenga, Michael Hudson, Steve Keen,
Ellen Brown
(2) QE3 the wrong medicine; debt forgiveness is needed - Stephen S. Roach
(3) How debt forgiveness enabled Japan to rise from the ashes of WWII -
Richard A. Werner
(4) Richard A. Werner's solutions to the European & Japanese internal
debt crises (excerpts)

(1) Richard Werner cf Stephen Zarlenga, Michael Hudson, Steve Keen,
Ellen Brown

- Peter Myers, December 7, 2012

I never see Richard Werner's name pop up in the blogosphere. Don't
neglect this man. A Professor of International Banking, his writings on
money, and in particular Central Banks, should bring him to the fore in
any discussions about how to revive the economy.

Stephen Zarlenga, Michael Hudson, Steve Keen, Ellen Brown and others
have a place at the table too.

Some propose more radical solutions - such as Zarlenga. But Werner
offers a way to escape from Depression and Deflation while preserving
Capitalism - admittedly with an interventionist government.

The trajectory and depth of the crisis goes will determine which
solution is eventually chosen.

Debt Forgiveness is promoted by Michael Hudson, Steve Keen, and Stephen
S. Roach (item 2).

Werner shows how it was done in 1945, allowing Japan to rise from the
ashes of the war (item 3).

(2) QE3 the wrong medicine; debt forgiveness is needed - Stephen S. Roach

Macro Malpractice

Stephen S. Roach

Sep. 30, 2012


NEW HAVEN – The wrong medicine is being applied to America’s economy.
Having misdiagnosed the ailment, policymakers have prescribed untested
experimental medicine with potentially grave side effects.

The patient is the American consumer – the world’s biggest by far, but
now in the throes of the worst funk since the Great Depression. Recent
data on consumer spending in the United States have been terrible.
Growth in inflation-adjusted US personal consumption expenditures has
just been revised down to 1.5% in the second quarter of 2012, and
appears to be on track for a similarly anemic increase in the third quarter.

Worse, these numbers are just the latest in what has now been a
four-and-a-half-year-old trend. From the first quarter of 2008 through
the second quarter of 2012, annualized growth in real consumption
spending has averaged a mere 0.7% – all the more extraordinary when
compared with the pre-crisis trend of 3.6% in the decade ending in 2007.

The disease is a protracted balance-sheet recession that has turned a
generation of America’s consumers into zombies – the economic walking
dead. Think Japan, and its corporate zombies of the 1990’s. Just as they
wrote the script for the first of Japan’s lost decades, their
counterparts are now doing the same for the US economy.

Two bubbles – property and credit – enabled a decade of excessive
consumption. Since their collapse in 2007, US households have
understandably become fixated on repairing the damage. That means paying
down debt and rebuilding savings, leaving consumer demand mired in
protracted weakness.

Yet the treatment prescribed for this malady has compounded the problem.
Steeped in denial, the Federal Reserve is treating the disease as a
cyclical problem – deploying the full force of monetary accommodation to
compensate for what it believes to be a temporary shortfall in aggregate

The convoluted logic behind this strategy is quite disturbing – not only
for the US, but also for the global economy. There is nothing cyclical
about the lasting aftershocks of a balance-sheet recession that have now
been evident for nearly five years. Indeed, balance-sheet repair has
barely begun for US households. The personal-saving rate stood at just
3.7% in August 2012 – up from the 1.5% low of 2005, but half the 7.5%
average recorded in the last three decades of the twentieth century.

Moreover, the debt overhang remains massive. The overall level of
household indebtedness stood at 113% of disposable personal income in
mid-2012 – down 21 percentage points from its pre-crisis peak of 134% in
2007, but still well above the 1970-1999 norm of around 75%. In other
words, Americans have much farther to go on the road to balance-sheet
repair – which hardly suggests a temporary, or cyclical, shortfall in
consumer demand.

Moreover, the Fed’s approach is severely compromised by the so-called
zero bound on interest rates. Having run out of basis points to cut from
interest rates, the Fed has turned to the quantity dimension of the
credit cycle – injecting massive doses of liquidity into the collapsed
veins of zombie consumers.

To rationalize the efficacy of this approach, the Fed has rewritten the
script on the transmission mechanism of discretionary monetary policy.
Unlike the days of yore, when cutting the price of credit could boost
borrowing, “quantitative easing” purportedly works by stimulating asset
and credit markets. The wealth effects generated by frothy financial
markets are then presumed to rejuvenate long-dormant “animal spirits”
and get consumers spending again, irrespective of lingering
balance-sheet strains.

There is more: Once the demand problem is cured, according to this
argument, companies will start hiring again. And then, presto – an
unconventional fix magically satisfies the Fed’s long-neglected mandate
to fight unemployment.

But the Fed’s policy gambit has taken the US down the wrong road.
Indeed, the Fed has doubled down on an approach aimed at recreating the
madness of an asset- and credit-dependent consumption model – precisely
the mistake that pushed the US economy toward the abyss in 2003-2006.

Just as two previous rounds of quantitative easing failed to accelerate
US households’ balance-sheet repair, there is little reason to believe
that “QE3” will do the trick. Quantitative easing is a blunt instrument,
at best, and operates through highly circuitous – and thus dubious –
channels. Significantly, it does next to nothing to alleviate the twin
problems of excess leverage and inadequate saving. Policies aimed
directly at debt forgiveness and enhanced saving incentives –
contentious, to be sure – would at least address zombie consumers’
balance-sheet problems.

Moreover, the side effects of quantitative easing are significant. Many
worry about an upsurge in inflation, though, given the outsize slack in
the global economy – and the likelihood that it will persist for years
to come – that is not high on my watch list.

Far more disconcerting is the willingness of major central banks – not
just the Fed, but also the European Central Bank, the Bank of England,
and the Bank of Japan – to inject massive amounts of excess liquidity
into asset markets – excesses that cannot be absorbed by sluggish real
economies. That puts central banks in the destabilizing position of
abdicating control over financial markets. For a world beset by
seemingly endemic financial instability, this could prove to be the most
destructive development of all.

The developing world is up in arms over the major central banks’
reckless tactics. Emerging economies’ leaders fear spillover effects in
commodity markets and distortions of exchange rates and capital flows
that may compromise their own focus on financial stability. While it is
difficult to track the cross-border flows fueled by quantitative easing
in the so-called advanced world, these fears are far from groundless.
Liquidity injections into a zero-interest-rate developed world send
return-starved investors scrambling for growth opportunities elsewhere.

As the global economy has gone from crisis to crisis in recent years,
the cure has become part of the disease. In an era of zero interest
rates and quantitative easing, macroeconomic policy has become unhinged
from a tough post-crisis reality. Untested medicine is being used to
treat the wrong ailment – and the chronically ill patient continues to
be neglected.

(3) How debt forgiveness enabled Japan to rise from the ashes of WWII -
Richard A. Werner

Financial Crises in Japan during the 20th Century

by Professor Richard A. Werner, D.Phil. (Oxon)

Chair in International Banking,
School of Management,
University of Southampton
Southampton SO17 1BJ

Vertretung: Chair for Monetary Theory and Policy
Faculty of Economics and Business Administration,
Department of Money and Macroeconomics,
House of Finance, 3 F.,
Goethe University, Grüneburgplatz 1 D-60323

6 June 2009

Bankhistorisches Archiv, Beiheft 47 (2009), pp. 98-123


{visit the above link to see and save the whole paper including charts.
The text comparing the BoJ's failed intervention in the 1990s compared
to the successful intervention after 1945 is excerpted below, without

{p. 2} Japan experienced a number of substantial financial crises during
the 20th century. Among them were banking crises that centred on the
banking sector but that engulfed the entire financial sector and either
threatened to or did in fact have an adverse impact on the economy. The
most gregarious ones are the crises of 1920, of 1927, of 1945 and the
most recent crisis, which began in about 1992 and lasted for over a
decade, until at least 2003. ...

{p. 3} The banking sector was again thrown into a state of crisis in
1945, when the vast programme of compulsory war-time credit expansion to
the munitions industry on the one hand and the government on the other
came to an abrupt halt, without the military success that provided the
ex ante justification. With Japan’s defeat a sober accounting of the
state of the banking system revealed a virtually total failure of assets
and hence strictly speaking a state of insolvency.

Finally, the most recent crisis occurred again after a major economic
boom – the ‘bubble economy’ of the 1980s. While this crisis began in
slow-motion in about 1992 and culminated in a final climactic spasm in
2003, in certain respects the negative impact on the economy continues
to be felt today, as bank lending continues to grow at a historically
slow pace. Thus it could be argued that this banking and economic crisis
has become fused with the global financial crisis that began in 2007 and
may not be over after almost two decades.

As already indicated, I am in this paper also concerned by a second
topic, namely the link between banking and the economy. It is during
times of crisis in the banking sector that this link becomes more
apparent, and the study of banking crises is thus important for
extracting insights concerning its features, role and influence. In the
case of the above Japanese banking crises of the twentieth century, the
developments in the banking sector indeed appear to have been of
significance for the performance of the economy.

Especially the two most recent banking crises posed an unprecedented
number of major challenges to mainstream macroeconomic and monetary
economic theory. In particular, theory has found it difficult to
pinpoint the mechanism that links banking crises and economic
performance. It is the extent of the recent crisis and the striking
number of analytical ‘anomalies’ that cannot be explained by standard
theories that make it so interesting and worthwhile to consider at
length. ...

{p. 10} 3. The Japanese banking crisis of the 1990s and the challenge to
economic theory Details of the 1990s banking crisis are discussed
elsewhere (see Werner, 1992, 1997b, 1999b, 2003b, 2004b, 2005). In
brief: Banks had extended credit irresponsibly in the 1980s and from
about 1992 onwards began to realise that their loan portfolios were
likely to be worth less than they had anticipated. Non-performing loans
(NPL) began to rise, although for almost a decade official NPL figures
remained an underestimate of the true extent of the problem. Banks
reacted predictably: they became more riskaverse and reduced their
extension of new credit. Bank credit growth declined significantly from
about 1991 onwards. From about 1997 onwards, the growth rate became
negative. Bank credit only staged a modest recovery in late 2005 (see
Figure 3).

{p. 11} While the state of the banking sector continued to deteriorate
steadily during the 1990s, the central bank and the government were
reluctant to take any decisive measure to address the problem. However,
the banking sector on its own found it impossible to escape from the
vicious cycle that had evolved: non-performing loans made banks
reluctant to extend credit. Lack of credit was cited by a large number
of companies, especially small and medium-sized firms, as the reason for
their own problems. As these credit-rationed firms cut back operations,
including employment, demand weakened. This increased bankruptcies
(Figure 4).

The increased number of bankruptcies raised the amount of non-performing
loans. That rendered banks even more risk-averse. The downward spiral
continued (Figure 5). Annual bankruptcy numbers rose from less than
10,000 in 1991 to over 30,000 per annum by the end of the decade. There
were many other features of utmost financial distress, including the
worrying rise of suicides to record highs. According to the Metropolitan
Police Agency, the majority of their increase during the 1990s was due
to recession-related – and, specifically, debt-related – problems.

{p. 12} Meanwhile, overall economic growth fell sharply, and inflation
receded, yielding to deflation (Figures 6 and 7).

{p. 13} As some voices had warned in good time (Werner, 1991, 1992,
1994, 1995, 1996), the banking sector was unable to extricate itself
from the vicious downward spiral without suitable help from the central
bank and the government. Central bank and government were not entirely
inactive. They adopted orthodox policy prescriptions: The central bank
began a series of interest rate reductions, starting with a reduction
when shortterm interest rates were 7% in 1991, and ending with
short-term interest rates at 0.001 more than ten years later. The
government implemented a series of fiscal expenditure packages,
beginning in 1992. In aggregate, these amounted to what then was the
largest peace-time fiscal expenditure programme in the post-war era. As
had been predicted early on, neither of these policies would have the
desired result (Werner, 1991, 1992, 1994, 1995, 1996). From about 1995
onwards, the government therefore took the view that demand management
policies having failed, supply-side reforms were required: it adopted a
far-reaching structural reform programme, which was implemented from
1996 onwards. However, as critics had warned (Werner, 1996), structural
reforms to raise the potential growth rate were likely to exacerbate the
deflation problem: if successful, the output gap between potential and
actual growth

{p. 14} would be widened. Indeed, from 1997 onwards, Japan witnessed
deflation – and holds the world record for the longest number of
consecutive years of deflation. By late 2009, Japan was back in deflation.

Meanwhile, the Japanese macroeconomic experience posed a profound
challenge to macroeconomic orthodoxy. In brief, all of the mainstream
theories – neo-classical (including supply-side), Keynesian,
post-Keynesian and monetarist – had been refuted by the Japanese
empirical record (see Werner, 2003b, 2005, 2007 for a detailed discussion).

These puzzles remain unexplained by orthodox theory. The monetarist
prescription to increase high-powered money (or their subset, bank
reserves) had been predicted to fail (Werner, 1995a,b,c) and did fail to
deliver, when the Bank of Japan adopted it in 2001 (under the
mis-appropriated label ‘quantitative easing’; this concept had earlier
been proposed and correctly defined by Werner, 1995c). The Keynesian and
post- Keynesian prescription of fiscal expansion had been predicted to
fail (Werner, 1995a,b,c) and did fail to stimulate the economy – each
package underperforming the ever more modest expectations of government
and private-sector economists – and merely left it saddled with record
debt. The so-called ‘credit view’ approach (consisting of the credit
rationing argument a la Stiglitz and Weiss, 1981; the bank lending
channel, a la Bernanke and Blinder, 1988, and the balance sheet channel
– see Bernanke and Gertler, 1995) failed, as interest rate policy failed
to have an additional positive impact via the bank lending channel, and
as it remained inexplicable why impaired banks should be a problem in an
economy with a thriving non-bank sector, healthy and hungry foreign
banks and foreign lenders, and capital markets that were more
deregulated than ever before. As noted above, the supply-side
prescription to deregulate, liberalise and privatise in order to
stimulate the economy also failed (as predicted by Werner, 1995a,b,c;
1996a,b; see also Werner, 2004a). Finally, the almost universal
prescription to lower interest rates had been predicted to fail (Werner,
1995a,b,c) and did fail to stimulate the economy despite a record number
of consecutive interest rate reductions and record-low interest rates.

The last point deserves further elaboration. It is often argued that the
‘liquidity trap’ argument, as advanced by Krugman (1998) and Ito (2000)
had solved the puzzle of ineffective interest rate policy. The facts
could not be further from the truth. The liquidity trap argument, as
propounded in the aftermath of the Japanese crisis, defines a liquidity
trap as the situation whereby interest rates have fallen to the lowest
level they can fall – so that no further falls are possible. It is then
argued that monetary policy stimulation becomes ineffective, since it is
defined as interest rate reductions, and fiscal stimulation will be
effective to escape from the liquidity trap.

There are a number of problems with this argument. Firstly, fiscal
stimulation was singularly ineffective in triggering a recovery in the
Japanese economy. Secondly, the liquidity trap argument fails to explain
why a liquidity trap occurs in the first place. Thirdly, the liquidity
trap argument, by its own definition, only applies to the Japan of March
2003, when both long and short term interest rates hit the lowest levels
on record. It thus says nothing at all about the period in question,
namely from 1992 to 2003. Fourthly, the interesting puzzle is why
interest rate reductions have failed to have the desired effect. The
liquidity trap argument is silent on this issue, as it is not concerned
with it: it only discusses the moment in time when short-term interest rates

{p. 15} have reached their lowest point (2003) and asserts that at this
point interest rate reductions will not work; which is true by
definition, hence rendering the argument a tautology without insights.
It remains altogether silent on why more than a decade of interest rate
reducations have been ineffective.

4. A model linking banks and the economy

While the orthodox approaches had failed spectacularly when confronted
with the challenge of the Japanese macroeconomic performance, an
alternative framework had been proposed as early as 1991 and 1992
(Werner, see also 1997, 1998, various publications), which renders
explicit the link between the banking sector and the economy, explains
and predicts banking crises and identifies successful policy responses
and policies to prevent banking crises.

This model can also account for a number of additional ‘anomalies’ or
‘puzzles’ that the mainstream approaches have had difficulties with,
such as the puzzle of the ‘velocity’ decline and ‘breakdown in the money
demand function’, the issue of recurring banking crises, of recurring
asset price bubbles and collapses, of Japanese net long-term capital
outflows (rising to record levels in the 1980s and collapsing in the
early 1990s), and, on a fundamental level, the issue of what makes banks
special, and how they are linked to economic performance. It is the
latter we will start with.

{p. 20} 4. The Japanese banking crisis of 1945

The problem

When the war ended in 1945, Japanese bank balance sheets were almost
entirely impaired: During the last, desperate years of the war, the
banks had been ordered to extend ever-increasing amounts of credit to
the munitions industries, on the one hand, and to the government on the
other; the latter largely in the form of war bonds or other government
IOUs. In 1945, two thirds of loans outstanding were to munitions firms,
many of which suddenly found themselves located outside Japan (in
territories that had previously been part of Japan) or insolvent. In
1945, with Japan defeated, the value of Japan’s war bonds was thought to
be close to zero, and the bloated forced loans to the war industries
were largely non-performing. If traded, these assets would fetch only a
fraction of their face value. While most bank assets were thus of little
value, bank liabilities still existed. Assets being smaller than
liabilities, and equity being insufficient to make up for the
difference, the banking system was technically bankrupt.

The problems are illustrated by a concerned cable from the Supreme
Commander for the Allied Powers (SCAP) in Japan to the Joint Chiefs of
Staff in October 1945: ”these concerns may be insolvent and loans
uncollectible. Banks also own investment in companies located in
non-Japanese area which will have to be written off. If these losses
taken probable that banks capital and surplus quickly wiped out”.

Tsutsui (1988) found that in 1945 the banks “were all virtually
insolvent, holding only worthless government bonds and debts from
companies in no position to repay. A nationwide financial crisis, with
mass bankruptcies, runs on the banks and the resulting social upheaval,
seemed a real threat in the first months, and even years, after the
surrender” (p. 23).

In addition, the commercial banks were weakened by the initial moves
toward zaibatsu dissolution: The U.S. authorities removed the securities
of major zaibatsu

{p. 21} group companies from the banks’ vaults for sales to the public.
These were both valuable assets and collateral for the banks (Tsutsui,
1988, Davis and Roberts, 1996).

While the cause of this banking crisis lay with the wartime government
policy, it remains within the framework outlined above, namely the
excessive creation of credit for unproductive purposes (munitions
manufacture being one of the least productive uses). However, the study
of this banking crisis shows that an impaired balance sheet – even under
such extreme circumstances – does not need to incapacitate a banking
system or an economy.

There can be little doubt that the asset problems of the banks were
sufficiently large to create a major credit crunch and deflationary
downturn of the economy. To counteract that possibility, credit needed
to be created. In the early post-war years there were many experts who
understood this (the leading bureaucrats at the Cabinet Planning Board,
Ministry of Finance, the Bank of Japan and the Ministry of
Commerce/Munitions Ministry – MITI’s predecessor – had not been educated
at US universities in neoclassical economics, but instead had studied
economics in Germany) and – quite unlike the 1990s – acted speedily to
achieve a recovery.

The wartime planning and credit allocation programme operated by the
government was re-instated soon after 1945. The Cabinet Planning Board
was revived in the form of the powerful but short-lived (1946–52)
Economic Stabilization Board (ESB or Keizai Antei Honbu), established in
August 1946 (Calder, 1993).

Initial attempts at solving this crisis were however thwarted by the US
occupation. Later policy initiatives were not fully supported by the
Bank of Japan. Thus policymakers struggled with political obstacles.

Government policies

We first consider the issue of impaired bank balance sheets. In the most
recent Japanese banking crisis, borrowers unable to service their loans
were eventually foreclosed on by the banks. This raised bankruptcies,
unemployment, non-performing loans of the banks and thus was a costly
process. By contrast, the post-1945 planners in Japan decided to avoid
this sequence of events by injecting government money to help borrowers
repay their loans, in the form of granting government indemnities to
those companies that had losses on government orders that were cancelled
due to the end of the war. The total amount of all indemnity claims
stood at Y70bn, a sum in excess of the total war damage to national
wealth and three times the central government revenues of 1945 (Nanto,

In other words, the Japanese government planned to inject tax money and
give it to the borrowers – thus keeping them alive – and enabling them
to service and repay their bank loans – thus helping improve the NPL
figures and hence balance sheets of the banking system. This way, the
same amount of public money injection would support the entire financial
‘food-chain’ from consumer to company employee to company balance sheet
to bank lender balance sheet. The modern equivalent of this policy would
be for the Federal Reserve to provide several trillion dollars worth of
money not to banks, but solely to the sub-prime borrowers, to enable
them to repay their loans and stay in their homes (with the
justification that the Fed had created the incentive structure for both
borrowers and lenders to embark on a credit spree). By

{p. 22} contrast, in the 1990s’ Japan government money was – eventually
– injected into the banking sector, but the borrowers were foreclosed
on. The same applies to most bank bail-out packages in response to the
so-called global financial crisis of 2008. Unfortunately, the innovative
Japanese policy initiative of 1945 was vetoed by the US occupation,
which insisted on taxing away any such payments to the private sector again.

Due to the US veto, this experiment could thus not be carried through.
All but Y18bn worth of indemnities were cancelled in 1946, creating the
threat of “a total financial collapse” (Tsutsui, 1988, p. 29) due to the
negative impact on financial institutions. “The effective cancellation
of the war indemnity payments forced much of industry into insolvency,
which in turn rendered virtually all financial institutions bankrupt.”
(Tsutsui, 1988, p. 29).

As a result, the Japanese government bureaucrats moved to ‘plan B’. This
centred on an expansion of credit creation via government-owned banks,
monetised fiscal policy (funded by direct borrowing from banks and the
central bank), and measures to dispose of non-performing assets.

Concerning the latter item, the goal was to establish ‘growth
consistent’ banking reform and ensure that economic recovery is not
hampered (see Werner, 2002c). For this purpose, another innovative
scheme was designed – and fully implemented – in record time. Instead of
the present-day model to establish ‘bad banks’ and separate them from
‘good banks’, Japanese bureaucrats ordered all bank loans and deposits
to be divided into ‘old accounts’ and ‘new accounts’. Initially, all
‘old accounts’ were frozen, while business could proceed in new
accounts. The banks had to follow a specific sequence for writing off
loans to firms bankrupted by the war indemnities cancellation and on
investments made in colonial and wartime enterprises (first by using
retained profits and reserves, then by the shareholders – up to 90% of
capital – and then by the creditors – first old depositors, then new
depositors). In the end, Y25 bn special losses were written off. 56
banks had to write off 90% of their capital; four could not meet their
obligations at all (Tsutsui, 1988).

Thanks to the provision for ‘new accounts’ “the bulk of the economy was
not seriously affected by the banks’ internal re-orderings.” (Tsutsui,
1988, p. 31). Meanwhile, 260 wartime financial institutions (such as the
Wartime Finance Bank etc.) with total assets of Y450 bn were liquidated
by SCAP. “By 1948, the banks had been restored to a solid financial
basis and prepared for a constructive role in Japan’s postwar revival.”
(Tsutsui, 1988, p. 35). The government was freed from crippling wartime
debts through cancellation of debts. “The liquidation of wartime banks
and the financial reorganisation were essentially complicated exercises
in accounting which, in effect, merely enabled the wartime financial
system to function under peaceful conditions. (Tsutsui, 1988, p. 35).

The second thrust of policy initiatives centred on the recognition that
credit creation had to be expanded, even though impaired bank balance
sheets were rendering banks more risk-averse. Initially, the Ministry of
Finance took the initiative, until such moves were thwarted by the Bank
of Japan and the occupation authorities, who favoured a greater role for
and monopoly of control over credit creation by the Bank of Japan.

{p. 23} The Economic Stabilisation Board initially used the
Reconstruction Finance Department inside the Industrial Bank of Japan
(IBJ, then still a government-owned bank) to supply the economy with
funding. In January 1947, this was separated and established as the
publicly owned Reconstruction Finance Bank (Fukko• Kinyu• Kinko), whose
job was to provide preferential funding to strategic industries (Okazaki
and Okuno-Fujiwara, 1999).5 This government bank was in turn funded by
government bills that the central bank had to discount (at the time, the
wartime Bank of Japan law remained in place, relegating the Bank of
Japan to the status of subordinated agency that had to receive orders
from the Ministry of Finance; the law and this status were changed only
in 1997, when the Bank of Japan became legally independent).

Second, the government planners took the initiative to re-establish the
priority production system from the wartime era with the 1947
Regulations on the Provision of Funds by Financial Institutions (Kinyu•
Kikan Shikin Yu•zu• Junsoku), announced by the Ministry of Finance.6 The
priority classification was simply switched from war objectives to
peacetime goals. Based on a “priority listing for lending industrial
funds,” limits were set on the maximum amount of loans each financial
institution could extend. A ranking was established of equipment and
operating funds for 460 types of business in four categories, A1, A2, B,
and C, “in almost exactly the same way as the financing arrangements
based on the wartime Emergency Funds Adjustment Law” (Okazaki and
Okuno-Fujiwara, 1999). The latter wartime law was replaced by the
Ministry of Finance with the equivalent Emergency Financial Order (Kinyu
Kinkyu Sochi Rei).

In accordance with the current Bank of Japan Law (promulgated in 1942),
The Ministry of Finance expected the central bank to act merely as its
agent by faithfully enforcing the Ministry of Finance’s instructions.
The central bank resented this, as well as the activities of the
Reconstruction Finance Bank, an institution that challenged its monopoly
on the control of the creation and allocation of credit (Yoshino, 1962).

Bank of Japan policies

Bank of Japan governor Ichimada, who had been an apprentice with Hjalmar
Schacht in the 1920s in Berlin (Werner, 2003), thus established a rival
credit allocation system at the central bank, which would direct funds
to the priority industries high on the list (Okazaki and Okuno-Fujiwara,
1999). Meanwhile, the implementation of the Ministry of Finance’s
priority lending categories was largely incapacitated: Ichimada achieved
this by assigning only a small section of eight to ten staff to this
complex task (Ministry guidelines had become quite detailed, running to
twenty pages), a group whose other job was the equally complex task of
administering frozen bank accounts from the wartime period (Tsutsui, 1988).

The Bank of Japan’s control over bank credit had already been asserted,
when the director of the Banking Department had issued instructions that
“in principle” banks were not allowed to increase their outstanding loan
balance beyond the balance of 20 March 1946 without a permit from the
Bank of Japan, as well as the government. This

{p. 24} prevented low-priority industries and consumers from laying
claims to scarce resources. Yoshino (1962) explicitly compares these
measures with Schacht’s credit control policies in the 1920s.

The Bank of Japan under Ichimada now adopted a two-pronged reflation
policy. First, while the banks were damaged by bad debts, Ichimada
turned the Bank of Japan itself into the banker to the nation. Schacht
had used active discounting of certain types of bills issued by official
organizations (such as Mefo) to selectively direct credit to priority
industries or projects. Ichimada did the same in the early post-war
years with his “stamped bill system,” under which companies in specific
sectors were invited to apply for funding directly, or via their banks,
to the Bank of Japan’s Banking department. The Bank of Japan discounted
or rediscounted bills of exchange from selected firms in the coal
industry, fertilizer manufacturing sector, textile fabrication industry,
and certain regional industries and exporters (which competed for export
trade bills to purchase necessary raw material imports) (Calder, 1993).
Retail, agriculture, education, and construction were then considered to
be of lower priority. Most domestic consumption-related industries fell
into the low-priority category. Sectors such as real estate, department
stores, hotels, restaurants, entertainment, publishing, and alcoholic
beverages—not to mention consumers themselves—were without much hope of
obtaining funds. Ichimada felt that Japan could ill afford such luxuries
(Ichimada, 1986). All this took place in the Loan Coordination Division
(Yushi Assenbu) of the Bank of Japan’s Banking Department.7

Banks were brought back into the process through help in restoring their
balance sheets and through Bank of Japan “guidance” of their discounting
of bills. Restoring banks’ balance sheets was partly achieved through
the system of old and new accounts. In principle, the most effective
method to achieve this, however, was through the special powers of the
central bank.

Ichimada merely needed to order the Bank of Japan to buy the banks’
worthless wartime bonds at face value – or at least significantly above
a potential (they were not traded) market price. In its own currency, a
central bank does not have to worry about bad debts. By purchasing them
and keeping them on its balance sheet, the central bank can neutralise
the negative impact of non-performing assets.8 This made the banks
dependent on the goodwill of the central bank, and willing to cooperate
with its informal guidance.9 If the central bank so wished, it could
extend unlimited funding to them. In the end, Ichimada had reinstated
full control over both the quantity of new bank loans and their sectoral
allocation in a mechanism that later became known as “window guidance”
(Yoshino, 1962).

{p. 25} In summary, the Bank of Japan bought war bonds/gov’t bonds from
banks at a price significantly above market value. It engaged in direct
lending to companies and loan syndication (shikin assen), whereby it
would bring borrowers and several lenders together. Further, it
regulated the quantity and allocation of bank credit creation (credit
controls), purchased financing bills issued by gov’t banks, notably the
Reconstruction Finance Bank, thus backing its activities with credit
creation. Finally, it lent directly to the government in order to
monetise fiscal policy


The post-1945 policies were spectacularly successful. A credit crunch,
deflation or even a recession were avoided. Banks were considered
healthy by late 1948. The central bank was not the only institution
deserving credit for this. The ESB’s activities, including the lending
by the Reconstruction Finance Bank, had played a major role. Government
deficit spending, as well as the Reconstruction Finance Bank, were
funded through the issuance of short-term financing bills or bonds that
the central bank had to discount. Demand accelerated as a result of the
expanded credit creation by the central bank and banks. There was no
deflation. Given the impairment of productive capacity due to the war,
however, inflationary pressures built up quickly. Further, the
government and central bank may not have coordinated their credit
creation policies; in aggregate they appear to have erred on the
expansionary side, producing inflation. This, however, was considered
acceptable by policy-makers at the time.

5. Evaluation of the comparative study and lessons for theory and policy

By all counts, the banking crisis of 1945 should have turned into a
major economic recession, if not worse. Meanwhile, the banking crisis of
1992 onwards was far milder, and thus by comparison it should have
produced a briefer period of economic recession. These expectations are
heightened by the fact that companies were virtually solely dependent on
banks for their external funding in 1945 and the early post-war years,
while during the 1990s many other options were open to them, including
funding from capital markets.

Meanwhile, the freer market system of the 1990s should, by the standards
of orthodox neoclassical economics, have helped return the economy to
full employment, while the pervasive government intervention of the war
and early post-war years should have resulted in a vast misallocation of

In this paper it is found that the difference between the outcomes of
the two banking crises is the policy response by the authorities. It was
the very interventionist approach of the early post-war era that made
the difference. However, it was intervention of a specific kind, namely
in the credit markets to create and allocate credit, and by making full
use of the central bank’s ability to create credit. ...

Werner, Richard A. (2009). Financial crises in Japan during the 20th
century. Bankhistorisches Archiv, 47, 98-123, available at

(4) Richard A. Werner's solutions to the European & Japanese internal
debt crises (excerpts)


pdf version:

Richard A. Werner (2012), How to End the European Crisis, University of
Southampton, CBFSD Policy Discussion Paper 2-12 | Centre for Banking,
Finance and Sustainable Development University of Southampton

{p. 1} How to End the European Crisis – at no further cost and without
the need for political changes

by Richard A. Werner, D.Phil. (Oxon)
Professor of International Banking
Centre for Banking, Finance and Sustainable Development

University of Southampton
31 July 2012


Executive Summary: True Quantitative Easing p. 2

1. How to solve the bad-debt problem in the banking system most
efficiently and cost-effectively. p. 3

2. Enhanced Debt Management: How to solve the sovereign funding problem
in the bond markets – and at the same time stimulate domestic demand p. 9

Further Reading p. 11

{p. 2} Executive Summary

There is a solution to the twin problem of large non-performing loans in
the banking systems and the funding crisis for sovereign borrowers that
is affecting especially Spain, Portugal, Ireland, Cyprus, Greece, but to
some extent also Italy and other countries.

The needed policies constitute 'true quantitative easing': I argued in
1994 and 1995 in Japan that there was no need for a recession in Japan
due to the bad debt problems in the banking system. Necessary and
sufficient condition for a recovery is an expansion in credit creation –
which I called 'quantitative easing', an expression that was later used
by central banks to refer to the type of traditional monetarist policy
(bank reserve expansion) that I had warned would fail.

True quantitative easing can be achieved quickly and without extra costs
in a two-part process as follows:

1. The central bank purchases all actual and likely non-performing
assets from the banks at face value (book value) and transfers them to
its balance sheet. In the case of non-securitised loans, if needed a law
should be passed to allow compulsory purchase by and reassignment to the
central bank.

2. The government stops the issuance of government bonds. Instead, it
funds any future borrowing requirement (including all scheduled 'roll-
overs' of bonds) by entering into loan contracts with the domestic
banks, borrowing at the much lower prime rate.

Ideally, these two measures are combined, and part and parcel of a
larger policy package. For a fuller list of measures, see our CBFSD
Discussion Paper No. 1-12.1

But they can also be implemented separately, so if ECB and national
central bank support cannot be gained for measure 1, national
governments can end the negative vicious cycle and end their sovereign
debt problems by going ahead on their own with part 2.

1 Richard A. Werner (2012), The Euro-Crisis: A to-do list for the ECB,
University of Southampton Centre for Banking, Finance and Sustainable
Development, CBFSD Policy Discussion Paper No. 1-12.

{p. 3} How to End the European Financial Crisis – at no further cost and
without the need for political changes

There is a solution to the twin problem of large non-performing loans in
the banking systems and the funding crisis for sovereign borrowers that
is affecting especially Spain, Portugal, Ireland, Cyprus, Greece, but to
some extent also Italy and other countries.

The needed policies constitute 'true quantitative easing': I argued in
1994 and 1995 in Japan that there was no need for a recession in Japan
due to the bad debt problems in the banking system. According to the
Quantity Theory of Credit, which I had introduced in 1991, and which
enabled me to predict the Japanese crisis and recession, I also pointed
out that it was avoidable if the right policies were taken: 2

Necessary and sufficient condition for a recovery is an expansion in
credit creation – which I called 'quantitative easing', an expression
that was later used by central banks to refer to the type of traditional
monetarist policy (bank reserve expansion) that I had warned would fail. 3

Sadly, the Japanese government did not adopt the recommended policies.
Neither did the Japanese central bank, which insisted on continuing to
rely on interest rate policies or, later, bank reserve expansion
policies (which it misleadingly called 'quantitative easing') – policies
I had warned would fail.

I believe the empirical record speaks for itself: Japan remains mired in
its twenty- year recession, soon to commence its third decade, while
national debt has topped 200% of GDP.

Fortunately for Europe, we now have the hindsight of the Japanese
experience and there is even less reason why one should adopt failed and
hugely costly policies, and turn down effective and costless policies.

In the following sections we discuss the two main pillars of the
policies I am recommending. For a full set of policies, please refer to
CBFSD Discussion Paper No. 1-12. 4

{p. 4} 1. How to solve the bad-debt problem in the banking system most
efficiently and cost-effectively.

The current approach adopted by the European and IMF leadership of how
to handle large and growing bad debts in the banking system, for
instance in Spain or Greece, is to ask the affected states to borrow
even more money. This is further use of public i.e. tax money (either
national, European or international), which is then used to recapitalise
banks and help them write off bad debts. This is a very expensive method
and adds to the already major problem of excessive sovereign debt.

Economics tells us that a zero-cost alternative is available, and has
indeed been adopted successfully in the past.

We must remember that the problem of insolvent banks, due to bad debts,
is fundamentally a standard accounting problem: the balance sheet of
banks shows a hole on the asset side: Instead of the original value of
assets of, say, 100, the market value of the assets has dropped. This
quickly produces a bust banking system, since already a fall in asset
values by ten percent means that most banks would have used up all
equity and thus would be bankrupt. Due to the nonperforming loans banks
have also become highly risk-averse and unwilling to grant new loans. As
a result, bank credit growth has slowed to zero or negative in many
European countries. This is why domestic demand will stay weak in Spain,
Ireland, Italy, Greece – if nothing is done to kick-start bank credit
growth. 5

How can this accounting problem of non-performing assets be solved? If
only we could use an eraser, rub out the nonperforming asset entries in
the accounts, and write in a market value of 100 again!

Actually, this can be done without suspending any accounting conventions
by one particular player: the central bank. Spain and Italy have
national central banks that have, according to the ECB, some discretion
over their asset purchases.

My proposal is for the national central banks to purchase all
nonperforming assets (actual, not official, since the official figures
understate the scale of NPLs) from the banks at face value (100).
Immediately the health of the banking sector would be fully restored.

Let's assume the market value of the NPLs is 20, but the central bank
has bought them for 100. While we have solved the problem for the banks,
have we not just shifted the problem onto the central bank balance
sheet? In other words, does the central bank not now face insolvency,
with a loss of 80 on its purchases of assets for a face value of 100
although they only have a market value of 20?

No, we have not just shifted the problem, we have solved it – and at
zero cost to the tax payer at that. Firstly, central banks do not need
to mark to market. Secondly, the central bank could in reality not
possibly make a loss of 80 on this transaction. Instead, it makes a
profit of 20. The reason is that the central bank has zero funding costs
for this operation, yet obtains something worth 20 – a gain, then, not a

5 The Quantity Theory of Credit tells us that a necessary and sufficient
condition for an economic recovery is an increase in credit creation
used for GDP transactions.

{p. 5} If it's so simple and costless, why has no central bank done this
before? Actually, three major central banks have done it before: the
Bank of England, the Bank of Japan and, most recently, the US Federal
Reserve. The result: the operations were a complete success, as was to
be expected. No inflation resulted. The currency did not weaken. Despite
massive non-performing assets wiping out the solvency and equity of the
banking sector, the banks' health was quickly restored. In the UK and
Japanese case, bank credit started to recover quickly, so that there was
virtually no recession at all as a result.

Details: The UK Case

It is August 1914. Britain has just declared war on Germany and its
allies (the Austro- Hungarian empire and the Ottoman Empire). However, a
substantial proportion of international financial transactions between
these Empires and the rest of the world were transacted through London,
so that upon the declaration of war, major parts of British banks'
assets consisted of securities and loans that could not be called and
were, due to the state of war, legally in default. The British banking
system was bust – and in a much worse situation than in 2007 or 2008
when most recently British banks became insolvent.

But since the Bank of England had no interest in creating a banking
crisis and credit crunch recession, it simply bought the non-performing
assets from the banks. There was no credit crunch, and no recession.
Problem solved. At zero cost to the tax payer.

Details: The Japanese Case

In August 1945 the balance sheet of Japanese banks was far worse than
their balance sheet in the 1990s or 2000s: non-performing assets
amounted to virtually 100% of assets (since assets consisted mainly of
forced loans to munitions companies and forced purchases of war bonds).
The firms were bankrupt. The government defaulted on the war bonds.

But in 1945 the Bank of Japan had no interest in creating a banking
crisis and a credit crunch recession. Instead it wanted to ensure that
bank credit would flow again, delivering economic growth. So the Bank of
Japan bought the non-performing assets from the banks – not at market
value (close to zero), but significantly above market value. The banks
were healed again. Together with some other measures, bank credit growth
recovered and so did the economy. 6

Details: The US Case

The Federal Reserve has been the central bank most active in
implementing this policy in recent decades. It purchased several
trillion dollars worth of non- performing assets from the US banking and
financial institutions. This drastically improved their balance sheets
and avoided default of many banks.

6 For more details on the Japanese case, see Werner, Richard A. (2009).
Financial crises in Japan during the 20th century. Bankhistorisches
Archiv, 47, 98-123, available at

{p. 6} How could the Federal Reserve have come up with this idea?
Chairman Ben Bernanke was an active participant in the wide-ranging and
intense policy debates in the 1990s in Japan which I was also active in,
and during which time I first proposed these and related policies under
the label of 'quantitative easing'. He had been one of the more
open-minded voices and often joined my criticism of the Bank of Japan
and calls for more drastic central bank action. He may also have read my
2001 book Princes of the Yen, an illegal, Bank of Japan-translated
English version of which circulated widely in Washington as early as
2001. The US State Department at the time also took an interest in my work.

In the original version of Princes of the Yen, I warn of how Alan
Greenspan was creating a massive boom-bust cycle that will burst,
causing financial dislocation in the US. 7 In the English Version of
Princes of the Yen I also warn of a major boom- bust cycle in Europe,
with the European asset bubbles caused by an excessively powerful and
unaccountable ECB. 8

In my 2005 book I again warned of the next bout of massive banking
crises, especially in Europe.


The immediate objection to this proposal is usually that it will produce
inflation. However, this cannot happen: inflation can only come about,
when those who are able to create money (the central bank and the banks,
collectively forming the banking system) inject money into the rest of
the economy (which is not able to create money). The asset purchases by
the central bank merely constitute transactions between the central bank
and the banks, re-ordering matters within the banking system. As a
result, not a single dollar is injected into the non-banking sector.
Hence there could not possibly be inflation.

This prediction has been borne out by the facts. When the Fed multiplied
its balance sheet size through its non-performing asset purchases, many
observers thought this would create inflation and sharply weaken the
dollar. Neither happened, for the same reason: no new money was injected
into the non-banking economy. So all kudos to Ben for his courage.
Incidentally, having averted a melt-down Dr. Bernanke now needs to
follow part 2 of my advice (see below), otherwise he could still face a
long recession.

{p. 7} Another objection was voiced to me by Jörg Asmussen, executive
director of the ECB, on 18 June 2012, as a fellow-panellist during a
public debate in Berlin. Obviously not having heard this proposal
before, and pushed by me and the audience to respond to my proposal and
the question why governments prefer to waste billions of tax money, when
the banks could be capitalised at zero new costs to the tax payer – the
highest ranking German official at the ECB responded by saying that such
a solution could not exist, 'because there is no free lunch'.
Admittedly, given the unimpressive set of policies we have been
presented with over the past two years, this almost sounds too good to
be true.

I was not given the chance to retort, and my response would have been:
make no mistake, this is no free lunch. We have experienced a massive
multi-year credit expansion in the banking systems in Ireland, Portugal,
Spain and Greece, which have produced asset bubbles and vast resource
misallocations, including millions of bankruptcies and home
repossessions. These are real and high costs to society. The collapse
that followed has greatly burdened government budgets and fiscal
expenditure on the non-banking part of the economy, such as welfare,
health and education, have been drastically cut. Unemployment has risen
to record levels in many periphery countries. These are massive real
costs – so I don't see how we can talk about a 'free lunch'. And
precisely because this crisis has been so immensely costly to society it
makes no sense whatsoever to further add to these costs through
misguided banking bail-out policies.

Finally, one often hears the objection that if we bail out the banks in
this way, won't they just get onto the same old tricks very soon – the
moral hazard argument. Well, we are bailing out the banks – using tax
money. And the moral hazard argument says that we should not use tax
money, for it was not the tax payers that have been responsible for the
bad debts. The principle is that who messes up should own up. So we do
need to ask the question of just who is responsible for the banking
crises that has befallen Ireland, Spain in particular, as well as
Portugal and Greece.

So who is responsible for the 25%, 30% or even 40% bank credit growth
that was recorded for months on end, until about 2007, in countries such
as Ireland, Portugal, Spain and Greece? Whose job is it to monitor and
rein in bank credit expansion? It is the job of the European Central
Bank. Did the ECB have the powers and tools available to prevent this?
It certainly did. The most powerful and independent central bank in the
world has complete freedom to choose its policy instruments and policy
targets. It chose to allow a vast credit bubble, which must result – as
these bubbles always do – in massive non-performing loans in the banking
systems. So since the ECB has been responsible, it should also pay up.

Political Obstacles

This policy is only possible with the cooperation of the central bank.
So if governments have given up control or influence over central banks,
as is the case in the European Union, the central bank has to be
convinced by rational economic argument of the superiority of this
measure in order to adopt it voluntarily. The reader is asked to
contribute to this up-hill battle by forwarding this report to anyone in
senior positions in society, business, academia, think tanks, parties,
bureaucracies or the political leadership.

Since independence is a great privilege that imposes the moral
responsibility on central banks to be transparent and accountable for
their policies, the ECB needs to explain to us why it is not inclined to
adopt such a policy. If national central banks

{p. 8} cannot be persuaded to voluntarily use their national discretion
to implement it, they should be asked to explain in great detail why
they oppose such a policy. My feeling is that the ECB leadership is
aware of the possibility of such a policy, but has (too early, in my
view) committed itself to a different course of action. Senior ECB
officials have squarely stated that they favour the adoption of a
banking union, Eurobonds, fiscal union, a European Finance Ministry and
even the creation of a United States of Europe. Quite a few ECB leaders
were personally connected to the people who co-authored the Maastricht
Treaty of 1991, or were, as is the case with Jean-Claude Trichet,
outright co-authors.

Their argument has so far been justified by the claim that, in
Thatcherite manner, 'there is no alternative'. This is why I want to
state categorically that there is an alternative that is economically
superior, will maintain the euro and does not require any of these
European centralisation measures.

Bloomberg has even raised the possibility that the ECB may cherish the
current ongoing slow-motion type of crisis, as it might consider it the
best opportunity to convince national politicians and the general public
to support the goal of the creation of a United States of Europe. ...

[...] But why do many observers anyway think the central bank should
step in? Because they believe that the central bank is the main creator
of the money supply. This is simply not true. The fact is that central
banks only create about 3% of the money supply. A full 97% of the money
supply is created by the private sector: the ordinary commercial banks
in each country. This ability to create the bulk of the money supply
makes them far superior to the bond market.

{p. 10} We thus advise governments to enter into loan contracts with the
commercial banks in their country. In other words, governments should
not borrow via the issuance of tradable securities, but through direct
credit lines from their banks. 10

Some observers believe that banks could not do this, because they 'do
not have the money'. Well, that's true. But this is true for any loan
granted by a bank. Which is why banks do not lend money, they create it:
banks are allowed to invent a deposit in the borrower's account
(although no new deposit was made by anyone from outside the bank) and
since they function as the settlement system of the economy, nobody can
tell the difference between these invented deposits and 'real' ones.
Actually, those 97% of the money supply are invented in this way.

Others object that a mere switch from government bonds to bank loan
contracts would not change much, or even anything. Well, in that case
they could not possibly object to trying it out. And if they did try it
out, they would be surprised at the significant difference it makes – a
difference of night and day:

This simple switch in funding, which I call 'enhanced debt management'
has a number of major advantages:

1. The borrowing rate is substantially lower. Governments receive,
according to Basel banking regulations, the lowest risk-weighting
(zero). Thus they can borrow from banks at their favoured-client rate,
which is the prime rate. The prime rate has been substantially lower
than the sovereign bond rate throughout this financial crisis. In the
case of Italy, we estimate that about E10bn can be saved in the next two
years alone on lower interest charges. Furthermore, governments will
deal with stable borrowing rates that are fixed throughout the loan
contract period (say 3 years). Movements in the bond market become far
less relevant.

2. The banks do not have to mark these loans to market. Moreover, they
are not affected by downgrades from credit rating agencies. This severs
the vicious negative feedback loop between banks and governments. At the
same time, however, the banks can use these loans fully as collateral
with the ECB for funding, as the ECB's announcement of 8 December 2011
makes clear.

3. Instead of a negative feedback loop, there is now a positive feedback
loop: banks will be happy to lend to governments, for one, because
sovereigns carry a zero risk weighting according to BCBS rules. This
means that banks will need zero new capital to back these loans.

10 I have presented this proposal in Japan in the 1990s: Richard A.
Werner (1998), Minkanginkoukarano kariire de keikitaisaku wo okonaeba
issekinichou, Economist (Japan), 14 July, 1998; It was also published in
English in the FT: Richard A. Werner (2000). Japan's plan to borrow from
banks deserves praise. Financial Times, 9 Feburary 2000; I also
personally explained it to government officials in Japan, among others,
to Hirohiko Kuroda, then vice-minister of international finance, who
liked it enough, as he told me, to pass it on to Andrew Smithers on his
visit to Tokyo – who in turn wrote it up in his reports, whence it
circulated in the City. It then came to be endorsed by Tim Congdon as
well as Martin Wolf. It is explained in greater detail in Richard A.
Werner (2005), New Paradigm in Macroeconomics, Palgrave Macmillan; A
recent application to Europe is in: Helmut Siekmann and Richard Werner
(2011), Eine einfache und gerechte Lösung der Schuldenkrise,
Börsen-Zeitung, 09.12.2011, Nummer 238, page 7.

{p. 11} 4. The main business of banks is to lend, but they are not
lending to the rest of the economy due to their risk aversion. Thus they
do not generate earnings to retain and rebuild their balance sheets.
Through my enhanced debt management, banks will rapidly grow their
balance sheets and earn decent income. Instead of primary market bond
underwriters, such as Goldman Sachs, earning large fees in cosy
relationships with semi-privatised public debt management agencies,
banks will be the beneficiaries of this business.

5. Despite the above major advantages, which alone would make this a no-
brainer, the single most important advantage of switching public funding
to loan contracts from banks has not yet been mentioned: it will boost
domestic credit creation – turning bank credit growth from zero or
negative growth to positive growth (of about 3% in the case of Italy).
This will increase demand and the money supply, ending the current debt
deflation spiral, and generate nominal GDP growth, in the case of Italy
between 3% and 4% above the growth otherwise possible. (This is the
result of our empirical nominal GDP model based on our Quantity Theory
of Credit).

Enhanced debt management that exits securitised debt markets and relies
on bank credit from the commercial banks will trigger an economic
recovery. It is the necessary second half of the policy that would
render the ECB's LTRO successful: as we have seen, bank credit is
currently still contracting, despite the LTRO. This would change

The economic recovery, triggered by a recovery in bank credit creation,
will increase tax revenues. Suddenly the negative spiral will be turned
into a positive one.

There is also a historical precedent for this type of policy: the
economics is the same as that of the system of short-term bills of trade
issued by semi-public entities in the years from 1933 onwards in
Germany, which were bought by the German banks, hence increasing bank
credit creation. These are known as 'Mefo Wechsel', after one of the
issuers, the Metallurgical Research Corporation. This method was
introduced by Dr. Hjalmar Schacht, President of the Reichsbank, the
German central bank, in 1933. 11

The method, which he called 'silent funding', was highly successful. As
I have argued elsewhere, the sharp German economic recovery from over
20% unemployment in early 1933 to virtually full employment by the end
of 1936 was the result of the ensuing expansion in bank credit creation
– in other words, it was the funding of fiscal policy through credit
creation that caused the recover, not fiscal stimulus per se. Japan's
experience of the 1990s has proven how even far larger fiscal expansions
will not boost the economy at all if they are not funded by credit
creation (see Werner, 2003, 2005).

In the 1930s the bills of trade were a preferable method at the time,
instead of direct loan contracts with banks, since banks did not have to
mark securities to market, and credit rating agencies did not exist. The
method I have suggested, of direct loans by banks to governments, is a
modern version that is more suitable to today's regulatory and financial
market environment. The effect of stimulating a recovery will be the same.

11 For further details, see Werner (2003).

{p. 12} Further reading:

Werner R. A. (1995). How to create a recovery through 'Quantitative
Monetary Easing'. The Nihon Keizai Shinbun (Nikkei), 2 September 1995
(morning edition), p.26 (in Japanese). English Translation available at

Werner R. A. (1997). 'Towards a new monetary paradigm: a quantity
theorem of disaggregated credit', with evidence from Japan. Kredit und
Kapital, Duncker and Humblot, Berlin, 30, pp. 276–309. available at

Werner R. A. (2002), 'How to Get Growth in Japan', Central Banking, vol.
XIII, no. 2, November 2002, pp. 48-54

Werner R. A. (2003), Princes of the Yen, Japan's Central Bankers and the
Structural Transformation of the Economy, M. E. Sharpe

Werner R. A. (2005), New Paradigm in Macroeconomics. Palgrave MacMillan.

Werner, R. A. (2009). Financial crises in Japan during the 20th century.
Bankhistorisches Archiv, 47, 98-123, available at

Buy at Princes of the Yen at

Buy New Paradigm in Macroeconomics at

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