Could England Be the Next Iceland?

Before you dismiss the headline as nutty, at least one respected macroeconomist and former central banker, and now chief economist of Citigroup is of the view that England is at risk of a currency crisis. He noted last November:

With the pound sterling dropping like a stone against most other currencies and credit default swap rates on long-term UK sovereign debt beginning to edge up, this is a good time to revisit a suggestion I made earlier on a number of occasions (e.g. here, here and here), that there is a non-trivial risk of the UK becoming the next Iceland.

The risk of a triple crisis - a banking crisis, a currency crisis and a sovereign debt default crisis - is always there for countries that are afflicted with the inconsistent quartet identified by Anne Sibert and myself in our work on Iceland: (1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity.

Gillian Tett provides an update on the UK's indebtedness, and the picture is not pretty. Admittedly, gross debt is not one of Buiter's signs of trouble, but it often translates into limited fiscal capacity. And England still has a large, internationally exposed banking sector. In fact, that is one reason to think the powers that be may not be bluffing at all when they seek to impose tougher rules on banks, and will accept their departure as a necessary consequence. England cannot afford to have an unconstrained banking sector. It cannot afford another crisis rescue operation. As General Pyrrhus famously said, "One more victory will undo me!"

From the Financial Times (hat tip reader Don B):

Which country experienced the biggest jump in debt, relative to gross domestic product, over the past decade?...if McKinsey consultants are to be believed, the real leverage giant - at least among the big western economies - is actually the UK. After crunching the data, McKinsey estimates that the gross level of British private and public debt is now 449 per cent of GDP - up from 350 per cent at the start of the decade.

And even excluding the liabilities of foreign banks based in the UK, the ratio still runs at 380 per cent - higher than any country except Japan (closely followed by Spain where debt has also spiralled dramatically, according to a McKinsey report issued today.*)

That is sobering stuff, particularly for UK voters. However, it also raises a much bigger point. In the middle of the last decade, it was often frustratingly difficult to get any data on leverage levels, since it was an issue on which precious few policymakers focused...

Now, of course, the world is radically different. But, as McKinsey points out, there is still surprisingly little known about the actual mechanics of "deleveraging", compared with, say, all that research that has been conducted on financial crises. And so it has tried to plug this gap by both plotting the recent pattern of global leverage levels - and then setting it in a wider historical context, to show how deleveraging has (or has not) occurred before...

Nevertheless, some of the patterns in the report are fascinating - and valuable -precisely because they have often been ignored. Contrary to popular perception, for example, McKinsey points out that, by historical standards, most of the financial world was not crazily leveraged in the past decade. Instead, the crazy debt increase was focused on a small group of brokers, and global banks.

Moreover, alongside the (limited) rise in broker borrowing in the past decade, there was also a far more startling increase in "real economy" debt, particularly in the household and real estate sector.

Yves here. Tett is surprised? She shouldn't be. Household debt grew rapidly in all countries experiencing housing bubbles. Although mortgage debt was obviously the main culprit, many (like the US, UK, and Australia) also featured impressive levels of unsecured borrowings, usually credit cards. Back to the story.

Since the crisis started, this "real economy" debt has declined a tiny bit, while financial sector leverage has fallen considerably. But since public debt has spiralled, gross leverage levels for most large nations have not fallen. And that, in turn, has a crucial implication: namely that, insofar as deleveraging is inevitable, much of it is still to come. From a historical perspective, this challenge is not entirely unprecedented. The UK and US have, after all, slashed vast debt burdens before during the last two centuries, and McKinsey has identified four dozen smaller deleveraging episodes around the world since 1950.

But while governments have sometimes softened this task before by creating rapid growth, often due to exports (via devaluation), or a peace dividend (after a war), those routes do not look offer an easy escape this time. Growth, in other words, could be tough to achieve. So that leaves three, unpalatable options, McKinsey suggests: outright default, inflation or belt-tightening.

McKinsey's best guess - or hope - is that belt-tightening will predominate, and it consequently forecasts a grim climate of austerity for the next decade. It may be right. But to my mind, at least, it remains a very open bet whether western voters will accept austerity without a backlash; personally, I would thus put a higher emphasis on the other options too.

Either way, the real moral is that the task now facing the western governments is monumental. It is a pity that groups such as McKinsey were not producing these leverage charts three years ago. If so, the politicians might now not be in quite such a pickle, even - or especially - in the UK.

Yves here. I cannot imagine McKinsey doing this sort of work three years ago. McKinsey is in the business of dispensing what I have long called leading edge conventional wisdom. Nothing so far ahead of the curve as to be threatening.