Carmen Reinhart: Dissecting Coronavirus Economic Impact and Recovery Options

Excerpt: Carmen Reinhart on how banks should deal with nonperforming loans

HOW DO WE AVOID a disastrous humanitarian crisis in developing countries as we emerge from the pandemic lockdowns? Will economic justice be harder or easier to attain after COVID-19? How do we get our nation back to work? Should we focus on the surging federal debt?

We asked several faculty members at Harvard Kennedy School for their insights on the central economic challenges as the United States and the world shift toward the recovery phase of the crisis. The ideas these scholars offered can assist political leaders and administrators who are making policy decisions at the federal, state, and local levels.

How we handle bad debts will determine success of economic recovery

While the coronavirus crisis did not start as a financial crisis, it may well morph into one of systemic severity. At the start of 2020, U.S. banks were better capitalized and household balance sheets stronger than at the onset of the global financial crisis in 2008. As COVID-19 paralyzed activity, banks have taken measures to protect themselves, increasing loan loss provisions and making accommodations to borrowers. Banks’ mortgage loan forbearance efforts, which are backed by the CARES Act, for instance, provide relief to households hit by the loss of income and employment.

Notwithstanding support from new Federal Reserve facilities, the critical question facing financial institutions is whether borrowers are ultimately able to meet the terms of the loans once the “grace period” ends. The answer depends critically on the duration of the pandemic and the speed of economic recovery. Even in a benign scenario, the damage already done to the balance sheets of banks, households, and businesses is substantive. Not all jobs will return and not all businesses will be able to reopen. A spike in defaults as 2020 unfolds is in the making. The historical experience with banking crises resolution suggests that a prompt and accurate acknowledgement of losses is the first step to a speedier recovery. Evidence suggests that kicking the can down the road in writing down bad debts may impair the effectiveness of monetary policy. In much of post-2008 Europe, the ever-greening of non-performing loans was a significant deterrent to the new credit needed to rekindle the economy. Let us avoid that mistake.