The UK's Financial Predicament
Last week the UK government announced new measures intended to prevent the British economy from imploding as a result of difficulties in the banking sector. Additional steps are needed because the investments in the banks announced in October, though widely applauded at the time, failed to restart bank lending to the economy. Instead, confidence in the banks has continued to ebb. As a result, coupled with the perception of external vulnerability of the economy, the City is being referred to as Reykjavik-on-Thames. This note offers a description of the measures and some assessment of their likely effects.
The measures announced by Chancellor Alistair Darling in the House of Commons involve:
- Creation of a £50 billion fund financed by the Treasury for the Bank of England to buy assets of the corporate sector from the financial sector. It is envisaged that this will sustain lending to the large-scale corporate sector.
- An order to the nationalized Northern Rock bank to stop running down its mortgage book, to sustain mortgage lending. (The government is also examining ways to restart mortgage lending to those who cannot afford a 25 percent deposit.)
- An expansion of the government holding in Royal Bank of Scotland (RBS), to a potential 70 percent, in return for a commitment to maintain lending to large companies and an increase of £6 billion in total lending in the next 12 months. Similar commitments will be negotiated on a case-by-case basis with the other banks.
- Insurance of certain bank assets, in return for a "commercial fee."
- Extension of the Credit Guarantee Scheme from April to December of this year.
- Government guarantees of UK mortgages of up to £50 billion.
These measures are additional to those that have already been announced: the £50 billion injection into the banks in October 2008, a series of cuts in the Bank of England's official lending rate, the nationalization of Northern Rock and the Bradford and Bingley Building Society, and a large increase in the size of the Bank of England's balance sheet fueled especially by the Bank's special liquidity scheme.
At the time, the injection of public capital into the banks last year was contrasted favorably with the Troubled Asset Relief Program (TARP) in the United States. It was reasoned that the problem was that many banks were being forced to reduce lending because many of their assets had turned bad, thus running down their capital at the same time as there had developed a general liquidity shortage caused by the reluctance to lend due to widespread uncertainty of the viability of the counterparty. The initial US solution was to buy bad assets from the banks; the British alternative was to increase the capital of the banks. Either approach could in principle resolve the problem, but the British approach had the great advantage of not requiring the bad assets to be priced, offset by a degree of public ownership of the banks.
Two questions seem to be crucial. One is the same as that which arose last October: Should the United States also adopt the approach of injecting money into the banks rather than buying their bad assets and so isolating them? The tradeoff is that outlined above: You have to agree on a price in order to buy bad assets under TARP or put them into a "bad bank," and this is liable to be at best contentious and at worst to offer the banks the opportunity of gaming the system.
But avoiding this dilemma and getting the upside benefit for the public involves at least the possibility of having to nationalize the banks. This was only a possibility in the United Kingdom in September, for the capital injections involved UK government purchases of preference shares, just as was subsequently done in the United States. But the preference shares bought in RBS have now been converted into common equity, which involves 70 percent public ownership, and full nationalization of at least some banks is now considered likely. Many Europeans may feel that they can live with what it is hoped will be only temporary nationalization. But is this true in the United States as well? Historically the public sector has not proved a good owner of banks
The other question is whether the new measures can be expected to see the United Kingdom through the crisis, and lay the basis for a recovery, without creating such heavy indebtedness of the UK government as to threaten a sovereign debt crisis. The guarantee of bank assets makes the UK government responsible for underwriting unspecified losses; perhaps the promise to charge a "commercial fee" will prevent the taxpayer from being saddled with an exorbitantly large sum, but this seems the most dangerous aspect of the proposals.
If global recovery starts fairly soon, one can perhaps be optimistic that the increase in British public-sector debt will be relatively modest. If, however, as seems increasingly likely, the recession continues throughout the year and deepens further, these measures may well not be adequate. They clearly do not in principle constitute a rigid limit of government intervention: The £50 billion limit on Bank purchases of corporate instruments can be increased; part or indeed all of the banking system can be nationalized, and so on. The question is at what point "the market" would decide that the UK government was no longer creditworthy, and a run on the pound analogous to the run on the Icelandic kronor would start.
The critical figure often mentioned is that the assets of British-based banks come to about 450 percent of British GDP. This may be compared to over 520 percent in the case of Iceland, over 400 percent in the case of Switzerland, a similar figure for Ireland, and more moderate figures for other countries. So if the British government had to acquire the whole of the British banking system and then found itself unable to realize any repayment or return from its assets, the gross debt/GDP ratio would increase to about 490 percent, a level much higher even than Italy or Japan.
The hypothesis is, of course, absurd: The bulk of assets of taken-over banks always prove to be good, one gets back a substantial return even on bad assets (so net debt would increase much less), and the British government still seems unlikely to be obliged to take over all the banks. But suppose that the gross debt/GDP ratio did increase to that vicinity: Would that constitute a rational ground for getting out of the pound?
There is a big difference between today and the days of sterling crises in the 1960s and 1970s: the alternatives. In those days the dollar was unquestioned, the DM had established a reputation as a hard currency, and the Swiss franc was unquestionably also hard. Today the dollar has only been saved from becoming a weak currency by its reputation as the most accessible funk-hole, Germany is linked in the euro with several Southern European countries that are viewed skeptically by the markets, and Switzerland suffers from a similar ratio of bank assets to GDP as the United Kingdom. True, that still leaves the Japanese yen; but Japan already suffers from a high debt/GDP ratio and a yen that is too strong for the economy to reach full employment. In the past there were several attractive alternatives to sterling; today the whole world is in a crisis and nowhere are there attractions sufficiently compelling not to be offset by a moderate devaluation (such as we already see).
Markets are not always rational, so one cannot be certain that complacency is the right attitude. But I do not see the basis for a prediction that the future for Britain is dire. Difficult, certainly, because Britain's leading sector of the last 25 years is likely to shrink to its natural size postcrisis, and so the country will have to rely on alternative activities. (Probably something old-fashioned, like manufacturing.) But the macroeconomic basis for this transition has already been laid, so even if the latest set of British measures do not suffice, there is not likely to be a total collapse.