A Bridge Loan? U.S. Should Guide G.M. in a Chapter 11

Tony Cervone, a spokesman for General Motors, has a warm and friendly way to summarize his ailing company’s ongoing dance with disaster.

“The fact is we’re looking at a short-term liquidity crisis that needs a bridge loan,” Mr. Cervone said this weekend to The Detroit Free Press.

To him, G.M. is merely in a temporary bind. If the government — that is, taxpayers — were just willing to spot G.M. some cash to get it over this little rough patch, everything would be just fine.

Mr. Cervone’s comment reflects what’s wrong with the mind-set in Detroit.

G.M is using money so quickly that a $10 billion infusion made today would disappear by February. That is why taxpayers shouldn’t fork over a cent, at least until shareholders are wiped out, management is tossed out and the industry is completely reorganized.

But there is a fix. Call it a government-sponsored bankruptcy, a G.S.B., if you will. It might sound a bit like an oxymoron, but it is an idea that has been quietly making the rounds in Washington. It makes a lot of sense.

Here’s how it could work:

First, let’s recognize that G.M. doesn’t need life support. What it needs is Chapter 11. The bankruptcy process is not a bad thing — indeed, it should be embraced. Bankruptcy allows companies to do tough things they could never do in the normal course of business. It has helped many companies turn themselves around and come out even stronger.

Bankruptcy would give G.M. enormous leverage with its debt holders — and, perhaps more important, with the U.A.W., whose gold-plated benefits are one reason G.M. is no longer competitive. A bankruptcy filing would also give G.M. the cover to close plants, rid itself of unprofitable brands and shed dealerships. In fact, unless G.M. files for bankruptcy, state laws would make it prohibitively expensive to shut dealerships.

So, first, the government would force G.M into a prepackaged bankruptcy now — even before policy makers may think it needs to be. As an inducement, the government would allow the merger with Chrysler to go forward. (There’s a lot of resistance to saving Chrysler too, but we need to look at the industry as a whole. And don’t worry: Cerberus, the private equity firm that owns Chrysler, would have its equity wiped out too.)

The merger should reduce costs by as much as $7 billion. But that’s not the tough stuff. The harder decisions are these: Both companies would have to jettison brands — lots of them. In the case of G.M., frankly, the only ones worth saving are Cadillac, Chevy and Buick. (Buick? Yes. Despite its lackluster sales and fuddy-duddy image in the United States, it’s a huge seller in China.)

That means Saturn, Pontiac, GMC and Saab would all disappear. Deutsche Bank estimates that reducing G.M.’s brands from eight to three would bring down the company’s cost base by $5 billion annually. If you’re able to shut the dealerships too, lop off another $4 billion. Chrysler is an even sadder situation: the only brand with any value is Jeep. Its Dodge Ram truck lineup could be merged with Chevy, which would also pick up pieces of the GMC business. And Chrysler’s minivan business could be combined into the Chevy brand as well.

In all, the 35 plants of G.M. and Chrysler would probably be cut by half.

Then the auto workers, whose benefits are off the charts.

G.M. currently employs about 8,000 people who actually don’t come to work. Those who do go to work are paid about $10 to $20 an hour more than people who do the same job building cars in the United States for foreign makers like Toyota. At G.M., as of 2007, the average worker was paid about $70 an hour, including health care and pension costs.

Those costs are already coming down slightly because of a renegotiated deal with U.A.W. last year, but not nearly enough.

Part of the problem is summed up by comments like this one in The Detroit Free Press, made by Kandy O’Neill, 39, an assembler at G.M.’s plant in Lake Orion, Mich., where she builds the Chevy Malibu and Pontiac G6. “I think we’ve given enough,” she said about the cuts to her salary and pension plan.

“Everybody wants to come down hard on the workers,” she said. “Nobody knows what we do inside there but the people who work there. It’s hard. It is not an easy job.”

When you read a line like that you might sympathize with her, but then you realize that nothing can be accomplished without bankruptcy. Ms. O’Neill: your company is asking the taxpayers — many of whom don’t have health care coverage — to pay your salary and health insurance.

And then we need these companies to agree to serious, strict enforcement of gas mileage standards. They should be producing the cleanest cars on the street. We may lose hundreds of thousands of jobs in this industry in the near term, but with the right kind of innovation, we should have millions of new jobs in the next 10 years.

Finally, we need to kick out management. That Rick Wagoner, chief executive of G.M., can say with a straight face that he still deserves to run this company is laughable. It would be impossible for him to put in place the serious changes that need to be made because he carries too much baggage. He’d have to undo years of his own neglect.

After all that is agreed, and only then, the government should come in with what’s known as debtor-in-possession financing to help the company through the bankruptcy process. Ideally, the government would be a “seed investor” and others would join it.

The goal should not be to keep these companies from filing Chapter 11, but from filing for Chapter 7 — which would mean liquidation.

With the debt market virtually closed, this is the time the government can come in and try to help. But to jump in front of the train now, without the requisite changes made to the industry first — which we all know can’t be done without Chapter 11 — would be foolish.

The automobile industry has argued that bankruptcy will be a disaster for the industry; that people won’t buy vehicles while they’re in bankruptcy for fear that the warranty won’t mean anything. There’s a fix for that too. The government should establish a warranty insurance fund that would insure the warranties of all G.M. and Chrysler vehicles bought while the combined company is still operating under bankruptcy protection. The cost to taxpayers should be next to nothing, assuming the company survives and can takeover the warranty obligations.

The government also should consider using some of the money for the financial industry rescue not to save the companies, but to retrain employees in the Detroit area and help promote development of new industry. A lot of people complain about the role of government in business and free markets. But it is hard to complain about efforts to make the nation’s workforce more employable.

Barack Obama, on “60 Minutes” Sunday night, said that government assistance must be “conditioned on labor, management, suppliers, lenders, all the stakeholders coming together with a plan.” He said, “So that we are creating a bridge loan to somewhere as opposed to a bridge loan to nowhere.”

It's an emergency. Long-term cures must wait

The world economy is suffering from two quite separate problems. Unfortunately they need contradictory solutions

Unemployment is soaring. Property and share prices are collapsing. Gordon Brown's borrowing plans are accused of driving Britain towards bankruptcy. Mervyn King, the Governor of the Bank of England, says that it is impossible to predict when the recession will be over and is pilloried for “losing touch with reality”. What is to be done?

When a patient is seriously sick - as the British and world economies clearly are at present - it is wise to make a careful diagnosis before prescribing the cure. The first step in this, as the Bank of England prepares for its next interest-rate cut and Mr Brown flies off to Washington for the global economic summit this weekend, is to decide who is qualified to make the diagnosis and who isn't.

Should we disqualify all those who failed to foresee the gravity of this crisis - a group that includes Mr King, Mr Brown, Alistair Darling, Alan Greenspan and almost every leading economist and financier in the world with the partial exceptions of Warren Buffett and George Soros? Speaking as a junior member of this confederacy of dunces, my answer is, not surprisingly, an emphatic “no”.

The reason for continuing to take seriously the views of the many so-called experts wrong-footed by this crisis is, however, more complex, and more enlightening, than the self-justification offered yesterday by Mr King. The Governor excused the Bank's past misjudgments on the grounds that economic performance is inherently unpredictable and “the world changed completely” in mid-September after the Lehman Brothers collapse. This is perfectly true, but not very helpful. The question raised by Mr King's refrain that “the world changed in September” is why this happened and whether this sudden transformation was inevitable.

The answer, to return to my medical analogy, is that the world was suddenly hit by a second, more dangerous disease in mid-September that was quite distinct from the chronic, but manageable, illness from which it had been suffering for the previous year. Correctly diagnosing these two separate ailments is absolutely crucial because they require different, and to some extent contradictory, cures.

The slow-moving cancer that the world economy was suffering until August was caused by excessive borrowing, property speculation and reckless and dishonest banking practices. A still-deeper cause of this credit cancer was the global imbalance between exuberant consumption and house-price speculation in America, Britain, Spain, Scandinavia and Eastern Europe, on one hand, and excessive saving and austerity, on the other, in China, Germany and Japan.

Dealing with this cancer required bankers to be disciplined, borrowing to be restrained and property prices to be gradually deflated to reasonable levels. Dealing with the deeper problem of global imbalances required consumers in the US and Britain to spend and borrow less, while the surplus countries invested and spent more. This cancer of globally unbalanced credit growth was not, however, immediately life-threatening to the world economy and the cures - tighter bank regulation and a gradual, orderly reduction in lending - could be administered relatively slowly over a long period. This is what the Bank of England and other central banks and governments around the world were trying, with moderate success, to do until early September.

The sudden collapse of the global banking system that followed the bankruptcy of Lehman - described by Mr King yesterday as probably the worst financial crisis in recorded history - was a separate affliction. Like a heart attack in a patient previously weakened by chemotherapy, it required a different clinical response.

Rather than a heart attack, the global banking collapse could perhaps be described as a bullet in the head, since its proximate cause was a conscious decision by the US Treasury to jeopardise the stability of the world economy in pursuit of an essentially political objective - to show that the Bush Administration was willing to act ruthlessly against at least one big Wall Street investment bank. Until that point, savers and investors around the world had assumed that financial institutions such as Lehman were “too big to fail” and would always be supported by their governments.

By shattering this belief Henry Paulson triggered a run on every important bank in the world and caused the sudden implosion of consumer and business confidence seen in the past two months.

Unfortunately, the cure for the post-Lehman collapse is totally different from the prescription for the credit and property boom. Instead of restraining lending, punishing banks and encouraging saving, policymakers have to do the opposite. They must support - and if necessary - subsidise banks, to create conditions for easier lending and borrowing terms and to do their utmost to encourage consumption.

The obvious ways to do this are to slash interest rates and taxes, especially taxes on consumption and on lower income households, who are most likely to spend rather than save any extra money that they are allowed by governments to keep.

To avoid a deep and prolonged depression, policymakers all over the world must be willing to cut interest rates to levels never before imagined - if necessary all the way to zero, as Mr King hinted yesterday - and to increase their budget deficits without any regard to the old rules of fiscal restraint. They must also be willing to let their exchange rates float without worrying about inflation - another controversial policy that Mr King rightly endorsed yesterday.

Luckily, the post-Lehman recession has made this possible by transforming the inflation outlook: oil and commodity prices have halved in just over two months.

If governments around the world are willing to pull out all the expansionary stops - and especially if they do this with some degree of co-ordination - then the risk of a prolonged global slump will be much smaller than generally believed. With interest rates near zero and big tax cuts made across the world, a robust recovery would probably begin by the middle of next year, starting in America and China, spreading to Britain and eventually reaching continental Europe in 2010.

But what of the pre-Lehman problems? Credit will have to be controlled in the long run through better regulation and tougher capital requirements; saving will have to be encouraged, especially in America and Britain, by higher interest rates; and consumption will have to be restrained with higher taxes. These higher taxes, in turn, will eventually narrow the government deficits that must be temporarily swollen to offset the post-Lehman slump. Any such long-term measures to restore global balance and encourage savings must, however, wait until the world economy has returned to robust growth.

There is no point in offering chemotherapy to a patient whose heart has stopped.

The next day I decided to try a new tactic. I told them that whichever one of them bugged me the least all day, didn't tattle and didn't bother the other one, would get fifty cents. But, if neither one of them bugged me or fought or tattled on each other, they would each get a dollar. I explained how they would have to work together to not bug each other, and to mediate disagreements by themselves. What followed was the most peaceful day I can remember in a long time! There was zero bickering, none! They each got their dollar and I told them the same deal would be on for the next day. And the next. And the next. Principles, schminciples. $14 a week is a cheap price to pay for peace and quiet.

The collapse of Iceland’s banks: the predictable end of a non-viable business model

Early in 2008 we were asked by the Icelandic bank Landsbanki (now in receivership) to write a paper on the causes of the financial problems faced by Iceland and its banks, and on the available policy options for the banks and the Icelandic authorities.

We sent the paper to the bank towards the end of April 2008; it was titled:

“The Icelandic banking crisis and what to do about it: the lender of last resort theory of optimal currency areas.”

On July 11, 2008, we presented a slightly updated version of the paper in Reykjavik before an audience of economists from the central bank, the ministry of finance, the private sector and the academic community.

It is this version of the paper that is now being made available as CEPR Policy Insight No 26. In April and July 2008, our Icelandic interlocutors considered our paper to be too market-sensitive to be put in the public domain and we agreed to keep it confidential. Because the worst possible outcome has now materialised, both for the banks and for Iceland, there is no reason not to circulate the paper more widely, as some of its lessons have wider relevance.

A banking business model that was not viable for Iceland

Our April/July paper noted that Iceland had, in a very short period of time, created an internationally active banking sector that was vast relative to the size of its very small economy. Iceland also has its own currency. Our central point was that this ‘business model’ for Iceland was not viable.

With most of the banking system’s assets and liabilities denominated in foreign currency, and with a large amount of short-maturity foreign-currency liabilities, Iceland needed a foreign currency lender of last resort and market maker of last resort to prevent funding illiquidity or market illiquidity from bringing down the banking system. Without an effective lender of last resort and market maker of last resort – one capable of providing sufficient liquidity in the currency in which it is needed, even fundamentally solvent banking systems can be brought down through either conventional bank runs by depositors and other creditors (funding liquidity crises) or through illiquidity in the markets for its assets (market liquidity crises).

Iceland’s two options

Iceland therefore had two options. First, it could join the EU and the EMU, making the Eurosystem the lender of last resort and market maker of last resort. In this case it can keep its international banking activities domiciled in Iceland. Second, it could keep its own currency. In that case it should relocate its foreign currency banking activities to the euro area.
The paper was written well before the latest intensification of the global financial crisis that started with Lehman Brothers seeking Chapter 11 bankruptcy protection on September 15, 2008. It does therefore not cover the final speculative attacks on the three internationally active Icelandic banks - Glitnir, Landsbanki and Kaupthing – and on the Icelandic currency. These attacks resulted, during October 2008, in all three banks being put into receivership and the Icelandic authorities requesting a $2 bn loan from the IMF and a $4 bn loan from its four Nordic neighbours.

Policy mistakes Iceland made

During the final death throes of Iceland as an international banking nation, a number of policy mistakes were made by the Icelandic authorities, especially by the governor of the Central Bank of Iceland, David Oddsson. The decision of the government to take a 75 percent equity stake in Glitnir on September 29 risked turning a bank debt crisis into a sovereign debt crisis. Fortunately, Glitnir went into receivership before its shareholders had time to approve the government takeover. Then, on October 7, the Central Bank of Iceland announced a currency peg for the króna without having the reserves to support. It was one of the shortest-lived currency pegs in history. At the time of writing (28 October 2008) there is no functioning foreign exchange market for the Icelandic króna.

In addition, outrageous bullying behaviour by the UK authorities (who invoked the 2001 Anti-Terrorism, Crime and Security Act, passed after the September 11, 2001 terrorist attacks in the USA, to justify the freezing of the UK assets of the of Landsbanki and Kaupthing) probably precipitated the collapse of Kaupthing – the last Icelandic bank still standing at the time. The official excuse of the British government for its thuggish behaviour was that the Icelandic authorities had informed it that they would not honour Iceland’s deposit guarantees for the UK subsidiaries of its banks. Transcripts of the key conversation on the issue between British and Icelandic authorities suggest that, if the story of Pinocchio is anything to go by, a lot of people in HM Treasury today have noses that are rather longer than they used to be.

The main message of our paper is, however, that it was not the drama and mismanagement of the last three months that brought down Iceland’s banks. Instead it was absolutely obvious, as soon as we began, during January 2008, to study Iceland’s problems, that its banking model was not viable. The fundamental reason was that Iceland was the most extreme example in the world of a very small country, with its own currency, and with an internationally active and internationally exposed financial sector that is very large relative to its GDP and relative to its fiscal capacity.

Even if the banks are fundamentally solvent (in the sense that their assets, if held to maturity, would be sufficient to cover their obligations), such a small country – small currency configuration makes it highly unlikely that the central bank can act as an effective foreign currency lender of last resort/market maker of last resort. Without a credit foreign currency lender of last resort and market maker of last resort, there is always an equilibrium in which a run brings down a solvent system through a funding liquidity and market liquidity crisis. The only way for a small country like Iceland to have a large internationally active banking sector that is immune to the risk of insolvency triggered by illiquidity caused by either traditional or modern bank runs, is for Iceland to join the EU and become a full member of the euro area. If Iceland had a global reserve currency as its national currency, and with the full liquidity facilities of the Eurosystem at its disposal, no Icelandic bank could be brought down by illiquidity alone. If Iceland was unwilling to take than step, it should not have grown a massive on-shore internationally exposed banking sector.

This was clear in July 2008, as it was in April 2008 and in January 2008 when we first considered these issues. We are pretty sure this ought to have been clear in 2006, 2004 or 2000. The Icelandic banks’ business model and Iceland’s global banking ambitions were incompatible with its tiny size and minor-league currency, even if the banks did not have any fundamental insolvency problems.

Were the banks solvent?

Because of lack of information, we have no strong views on how fundamentally sound the balance sheets of the three Icelandic banks were. It may be true, as argued by Richard Portes in his Financial Times Column of 13 October 2008, that “Like fellow Icelandic banks Landsbanki and Kaupthing, Glitnir was solvent. All posted good first-half results, all had healthy capital adequacy ratios, and their dependence on market funding was no greater than their peers’. None held any toxic securities.”¹

The only parties likely to have substantive knowledge of the quality of a bank’s assets are its management, for whom truth telling may not be a dominant strategy and, possibly, the regulator/supervisor. In this recent crisis, however, regulators and supervisors have tended to be uninformed and out of their depth. We doubt Iceland is an exception to this rule. The quality of the balance sheet of the three Icelandic banks has to be viewed by outsiders as unknown.

If there is a bank solvency problem, even membership in the euro area would not help. Only the strength of the fiscal authority standing behind the national banks (and its willingness to put its fiscal capacity in the service of a rescue effort for the banks) determines the banks’ chances of survival in this case. If there were a serious banking sector solvency problem in Iceland, then with a banking sector balance sheet to annual GDP ratio of around 900 percent, it is unlikely that the fiscal authorities would be able to come up with the necessary capital to restore solvency to the banking sector.

The required combined internal transfer of resources (now and in the future, from tax payers and beneficiaries of public spending to the government) and external transfer of resources (from domestic residents to foreign residents, through present and future primary external surpluses) could easily overwhelm the economic and political capacities of the country. Shifting resources from the non-traded sectors into the traded sectors (exporting and import-competing) will require a depreciation of the real exchange rate and may well also require a worsening of the external terms of trade. Both are painful adjustments.

If the solvency gap of the banking system exceeds the unused fiscal capacity of the authorities, the only choice that remains is that between banking sector insolvency and sovereign insolvency. The Icelandic government has rightly decided that its tax payers and the beneficiaries of its public spending programmes (who will be hard hit in any case) deserve priority over the external and domestic creditors of the banks (except for the insured depositors).

Conclusions, lessons and others who might be vulnerable

Iceland’s circumstances were extreme, but there are other countries suffering from milder versions of the same fundamental inconsistent – or at least vulnerable - quartet:
(1) A small country with (2) a large, internationally exposed banking sector, (3) its own currency and (4) limited fiscal spare capacity relative to the possible size of the banking sector solvency gap.

Countries that come to mind are:

• Switzerland,
• Denmark,
• Sweden

and even to some extent the UK, although it is significantly larger than the others and has a minor-league legacy reserve currency.

Ireland, Belgium, the Netherland and Luxembourg possess the advantage of having the euro, a global reserve currency, as their national currency. Illiquidity alone should therefore not become a fatal problem for their banking sectors. But with limited fiscal spare capacity, their ability to address serious fundamental banking sector insolvency issues may well be in doubt.

How likely is a sterling crisis or: is London really Reykjavik-on-Thames?

November 13, 2008

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.

The argument is simple. First consider the case where the banking sector is fundamentally solvent, in the sense that its assets, if held to maturity, would cover its liabilities. Iceland’s banks were supposed to have been in that position, although I have seen no verifiable information on the quality of the three formerly internationally active banks. There is no such thing as a safe bank, even if the bank is sound. Without an explicit or implicit government guarantee, there is always the risk of a bank run (a withdrawal of deposits or a refusal to renew maturing credit and to roll over maturing debt) or a sudden market seizure or ’strike’ in the markets for the bank’s assets bringing down a fundamentally sound bank.

To prevent a fundamentally sound bank succumbing to a deposit run or to asset market illiquidity, the central bank has to be able to act as lender of last resort, providing funding liquidity and as market maker of last resort, providing market liquidity to liquidity-constrained banks.

If the country has an internationally active banking and financial sector and if its foreign currency liabilities have a shorter maturity than its foreign currency assets, and especially if these foreign currency assets have become illiquid, the central bank has to be able to act as foreign currency lender of last resort and market maker of last resort if it is to be able to guarantee the survival of the banking sector when faced with a deposit run and/or illiquid markets for its assets.

The central bank of Iceland could be an effective lender of last resort in Icelandic krona, as it can print the stuff in unlimited quantities. It can be a lender of last resort and market maker of last resort in other currencies only to a limited extend - limited by the fact that the Icelandic krona is not a global reserve currency and by the fiscal spare capacity of the Icelandic sovereign.

If Iceland had been a member of the euro area, its central bank would have been part of the Eurosystem - the euro area central bank consisting of the ECB and the (currently 15) national central banks of the euro area member states. The euro is the junior of the two global reserve currencies. First is the US dollar, with around 64 percent of global official foreign exchange reserves held in US dollars. The euro’s share is around 27 percent. After the euro, there is nothing. Sterling’s share of 4.7 percent (at the overly flattering strong sterling exchange rate of late 2007) reflects its minor-league legacy reserve currency status. The Japanese yen and Swiss franc are completely irrelevant as global reserve currencies.

Clearly if a country has a major-league global reserve currency as its national currency, two consequences follow. First, it is likely to be able to borrow abroad using instruments denominated in its own currency rather than in that of the currency of the lender or some other global reserve currency - they are less affected by ‘original sin’ - in the currency-denomination-of-external-debt sense of the expression. Second, it will be possible for both private parties and for official parties like the central bank, to arrange access to foreign exchange (through swaps with other central banks, credit lines etc.) more easily and on better terms than are available to private parties, central banks and other official agents not blessed with a global reserve currency of their own.

As a member of the euro area, it would have been much easier and cheaper for Iceland to defend itself against speculative attacks on its banks - provided the banks and its government were indeed solvent and perceived to be so. With the krona, not only could solvent banks be brought down, even a solvent but illiquid (in foreign exchange) government could be brought down by a sufficiently large speculative attack on the banks, the currency and the public debt.

Of course, even with the euro, the banks could not have been saved by the Icelandic authorities if the banks were fundamentally unsound and if the government did not have the fiscal strength to recapitalise the banks. Under current circumstances, if the government injects capital into a bank to compensate for past and anticipated future losses, it may not achieve a risk-adjusted expected rate of return on this investment equal to its borrowing cost. The difference will have to be recouped through higher future primary surpluses, that is, higher future government budget surpluses excluding interest payments. If there is doubt in the markets about the ability or willingness of current and/or future governments to raise future taxes or cut future spending to generate the required increase in future primary surpluses, the default risk premium on the public debt will rise. We are seeing such increased default risk premia even for the most credit-worthy sovereigns, including the German government, the US government and the UK government. On Friday October 10, 2008, the spreads on 5 year sovereign CDS were 0.456% for the UK, 0.33% for the USA ad 0.265% for Germany, well above their post-war historical averages. On October 28, 2008, Bloomberg wrote:

“Credit-default swaps on [U.S.] Treasuries have risen nearly 40 percent since TARP was signed into law Oct. 3, and are now about the same as Mexican and Thai government debt before the credit markets began to seize up in June 2007.”

By bailing out the banks, and other bits of the financial system, the authorities reduce bank default risk but by increasing sovereign default risk. As long as there is sufficient fiscal spare capacity (the technical, economic and political prerequisites are met for raising future taxes and/or cutting future public spending by a sufficient amount to service the additional public debt and maintain long-run government solvency).

Iceland’s government did not have the fiscal resources to bail out its banks. All three internationally active banks were put into receivership. The domestic bits then were bought by the government out of the receivership. The Icelandic krona collapsed and is no longer internationally convertible: exchange rate restrictions have been imposed. It is an open issue whether Iceland will default on some of its sovereign debt obligations as well.

How and to what degree is this relevant to the UK? Iceland is a tiny country (about 300,000 people - the size of the city of Coventry). The UK has a population of over 61 million. Nevertheless, the UK is a small open economy for economic purposes: it is a price taker in the markets for its imports and exports and in global financial markets. Its share of world GDP in 2007 was 3.3% (at PPP exchange rates - somewhat higher at market exchange rates). Its currency is no longer a serious world reserve currency.

The UK banking sector’s balance sheet is about half the size of the Icelandic banking sector as a share of annual GDP: just under 450% at the end of 2007 as compared to Iceland’s almost 900%. Switzerland, another vulnerable country (small, no currency with global reserve currency status , large banking sector relative to GDP and limited central government fiscal capacity) has a banking sector balance sheet of just over 650% of annual GDP. With UK annual GDP around £1.5 trillion, that gives us a banking sector balance sheet of well over £ 6 trillion.

The first Chart below shows the size of the balance of the UK banking sector. This includes the Bank of England. If we exclude the Bank of England, the latest observation on the balance sheet of the banking sector and a percentage of annual GDP would still be around 420 percent. The deleveraging of the banking sector, visible at the very end of the sample period, has much further to go. The Chart also shows that foreign currency assets and liabilities of the banking sector are very evenly matched - the two lines are almost indistinguishable. Both now are just below 250% of GDP. I don’t have any data on the degree of mismatch by individual currency. Just the aggregate foreign currency exposure is shown.

While there is no net foreign exchange exposure of the banking system in the UK, banks are banks. The foreign currency liabilities of the banking system are therefore likely to have shorter maturities than the foreign currency assets. The foreign currency assets are also likely to be less liquid than the liabilities. I don’t have information on the maturity and liquidity composition of foreign currency assets and liabilities to confirm or refute this presumption. Let me just say that Iceland’s banks were brought down despite an aggregate match between foreign currency assets and foreign liabilities.

Chart 1

Source: Office for National Statistics

Not only are the UK banks rather large relative to the size of the economy, the gross external assets and liabilities of the British economy are also hefty - about the same size relative to UK GDP as the total assets of the banking sector (there is no deep reason for this coincidence). Chart 2 below shows the gross external asset and liability position and the net foreign investment position of the UK. While not in the Iceland league (Iceland had gross foreign assets and liabilities of around 800 percent of annual GDP at the end of 2007) the UK, with gross foreign assets and liabilities of well over 400 percent of annual GDP does look like a highly leveraged entity - like an investment bank or a hedge fund. By contrast, gross external assets and liabilities of the US straddle 100 percent of annual GDP.

Chart 2

Source: Office for National Statistics

Foreign currency illiquidity risk for the UK banks and authorities

Assume for the sake of argument that the UK’s banks are sound. Most of them obviously are not, which is why so many of them have had capital injected into them by the government, and why all of them benefit from explicit government guarantees on new bank debt issuance and implicit government guarantees that the government will come to their assistance should they be at risk of insolvency. With foreign currency assets of longer maturity and less liquid than foreign liabilities, the banks and the country would still be vulnerable to a foreign currency run on the banks (a refusal to renew foreign currency credit) or a seizing up of the markets in which the banks’ foreign currency assets are traded. The Bank of England’s foreign currency reserves are puny and the government’s foreign currency reserves are small - around US$43 billion, pocket change, really.

No doubt the Bank of England would be able to arrange swaps, credit lines or overdraft facilities with the systemically important central banks - the Fed, the ECB and the Bank of Japan. Given sound banks and sound fiscal fundamentals, it should be possible for the UK to defend the banking sector against runs or market strikes. There would, however, be a cost involved - the cost faced by any issuer of a currency that is not a global reserve currency and who therefore either has to insure ex-ante against the possibility of running short of global reserve currencies, or risk getting clobbered on the terms of an emergency currency swap or similar arrangement cobbled together when the enemies are already scaling the ramparts.

This cost of insuring against foreign currency illiquidity risk will make the City of London less competitive as a global financial center than rivals based in global reserve currency jurisdictions. It provides another strong argument for the UK adopting the euro and for the Bank of England becoming part of the Eurosystem as soon as the other EU member states will let it.

The reason the costly handicap of a minor-league currency does not appear to have harmed the UK in the past is the same as the reason why I have not made the argument in the past. Before the current financial crisis, no-one could conceive of a world in which a financial crisis would start in the global financial heartland - Wall Street and the City of London - rather than in some developing country or emerging market, would paralyze most systemically important wholesale financial markets and lead to the government nationalising much of the north Atlantic region’s banking and wider financial system and underwriting or guaranteeing the rest. Well, most of the world now knows that this is the way things can be. If it retains sterling, the City of London will put itself at a competitive disadvantage (for those who remember then-Chancellor Brown’s Five Tests for euro area membership, this means that the fourth of these tests now has been met also).

Sovereign default risk for the UK

Even if the UK had the euro as its currency, its banks would still have been at risk if they were unsound (their assets, even if held to maturity, would not cover their financial obligations). In this case, bank insolvency would result unless the British authorities were both able and willing to bail them out. I assume in what follows that the government is willing to bail out the banks. The evidence thus far supports this.

Northern Rock and (rump) Bradford and Bingley were nationalised. The SLS allows all banks to swap illiquid asset-backed securities for Treasury Bills. For reasons that cannot be understood by ordinary mortals, the Treasury Bills lent/swapped by the SLS don’t count as public debt (something to do with Treasury bills with less than one year remaining maturity not being part of the public debt for some accounting and accountability purposes - don’t ask). The Bank of England is accepting a wider range of private securities as collateral at the discount window and in repos. The state has a 60 percent ownership stake in RBS and roughly 40 percent ownership stakes in HBOS and Lloyds-TSB. The government has made up to £25o billion available to guarantee new issuance of bank debt. The state stands behind the formal £50,000 deposit guarantee for bank retail deposits.

The key question is, can the government meet all these fiscal commitments, whether firm or flaccid, unconditional or contingent and explicit or implicit ? Does it have the resources, now and in the future, to issue the additional debt required to meet the growing volume of up-front obligations it has taken on?

To be solvent, the face value of the government’s net financial obligations has to be no larger than the present discounted value of current and future primary government surpluses (government surpluses excluding net interest and other investment income). The government argues that its net debt position is strong, with a net debt to annual GDP ratio still just below forty percent. That statistic is a prime example of lies, damned lies and government statistics.

The 40 percent excludes such old sins as the debt incurred through the PFI (private finance initiatives). This will be brought into the total soon. It also does not yet include the net debt of Northern Rock and Bradford and Bingley. It also excludes the debt of RBS, where the government owns a majority stake and the debt of Lloyds-TSB and HBOS, where the government has a controlling minority stake. Under normal accounting practices, the debt of all three banks will have to be counted as public debt in the future.

Three large UK banks, HSBC, Barclays and Abbey (Santander) have not yet taken the King’s shilling - they are attempting to meet the capital raising targets they agreed with the government from sources other than the government. All three banks are, however, heavily exposed to emerging markets (Santander mainly in Latin America, HSBC in Asia, the Americas, Europe, the Middle East, and Africa and Barclays in Europe, Africa and Asia). This has been a source of strength until recently, compared to their competitors who were mainly exposed to the USA and Western Europe. However, with all emerging markets now severely affected by the financial crisis (both directly and through trade links with Western Europe and the USA), what was a source of strength is become a further source of weakness. The likelihood that some or all of the banks that have not yet received capital injections from the government will do so in the not too distant future is rising steadily.

It is not at all far-fetched to hold the view that the British government has effectively guaranteed the balance sheets of the entire UK banking sector. Let’s value this conservatively at 400 percent of annual GDP, some £ 6 trillion. The value of this guarantee depends on the likelihood it will be called upon, and on the amount of money the government would have to come up with if the guarantee is called. Both numbers are highly uncertain and any guestimate is bound to be subjective. The expected payments under the guarantee are, in my view, hardly likely to be less than £300 bn (on top of any money already paid out), some 20 percent of annual GDP. It could be much higher. With a recession of unknown depth and duration looming, there is a material risk that the government would have to come up with a multiple of the £300 bn just mentioned.

Of course, the value of the assets acquired by the government as shareholder has to be set against the explicit and implicit liabilities it has taken on. I would like to see a valuation of the equity stakes of the government that does not benefit from the recent scandalous relaxation of fair-value accounting and reporting that was forced upon the IASB. I don’t believe any valuation that relies on managerial discretion. With the regulatory constraints likely to be imposed on banks in the future, and the lower returns associated with banking-as-a-public utility, the government may well be getting rather poor financial returns on its investment in the banks. While that does not mean the government should not have made the capital injections - the systemic externalities associated with the failure of large banks don’t show up in the share price - it does mean that the immediate fiscal burden of the capital injections is likely to be only partially offset by future dividends and (re-)privatisation receipts.

In addition to the debt that has been and will be issued to finance asset purchases by the government, there are the future debt issuance associated with the large cyclical and structural government deficits that will be a feature of the coming recession. If GDP falls peak-to-trough by, say 3.5 percent and recovers only slowly, we could have a seven percent of GDP or higher government deficit for 2009 and 2010. Together with the explicit or implicit fiscal commitments made to safeguard the British banking system, the numbers are likely to spook the markets.

With the true net public debt to GDP ratio probably already well above 100 percent of GDP and rising, and with massive public sector deficits, partly cyclical and partly structural, about to materialise, the markets will question the fiscal-financial sustainability of the government’s programme with increasing vehemence. The CDS spreads on UK public debt will start rising. The notion that, except for currency, there may not be a safe sterling-denominated asset may come as a shock. But the same is true in the US. In 2009, the US government will have to sell (gross) at least $ 2 trillion worth of government debt (the sum of the Federal deficit plus asset purchases plus refinancing of maturing debt). The largest such figure ever in the past was $550 billion. In the US too, the markets will have to learn to do without a US dollar financial instrument that is free of default risk.

The fiscal dire straits the UK government are in limits their capacity to engage in a discretionary fiscal stimulus to boost domestic demand. For it to be meaningful, a debt or money-financed stimulus of at least one percent of GDP and more likely two percent of GDP is called for. But if the market takes fright and believes that the government will not raise future taxes or cut future public spending by the amounts required to safeguard government solvency despite greater current borrowing, it will add higher default risk premia to the longer-dated UK sovereign debt instruments.

Such mistrust in the temporary nature of a fiscal stimulus would not be irrational. After its first term in office, the government have thrown fiscal restraint to the wind and have engaged in a steady increase in public spending as a share of GDP which has been only partly matched by an increase in the tax burden as a share of GDP. Rising debt and deficits and a fondness for fiscal and accounting gimmicks designed to hide the increase in the debt burden have undermined public confidence in the fiscal rectitude of the government. With enough mistrust, the interest rates will rise by enough to crowd out completely the stimulus to private demand provided by the tax cut or public spending increase. Lack of confidence in the government’s fiscal sustainability would also undermine confidence in sterling. In the worst case, we could see a run on the banks, on the public debt and on sterling all at the same time. This is not the most likely outcome yet, in my view. But it is a distinct possibility.

Could the government monetise the deficits instead (i.e. sell gilts to the bank of England)? The Bank would only be willing to buy such debt (either directly or indirectly in the secondary markets) if it was consistent with its interpretation of its price stability mandate. The Bank appears to believe that short rates may have to go down quite a bit further if it is not to undershoot the inflation target by the end of next year. It may also view the monetisation of gilt issuance as consistent with its mandate.

If there is a conflict between the Bank of England and the government, the government could invoke the Treasury’s Reserve Powers. This is a clause in the Bank of England Act that allows the government to take back the power to set rates from the Bank of England, under exceptional and emergency conditions. It has never been invoked.

If the deficits get monetised, there will not be the upward pressure on real interest rates that would result from debt financing. But the markets may fear the long-term inflationary consequences of the monetary financing, especially if it were to be done by the government after invoking the Treasury’s Reserve Powers. So long nominal rates would be likely to rise if monetisation of the government’s deficits were chosen. Monetisation of deficits would also weaken sterling further.

All may still end up well (cyclically adjusted well, that is). But the piling of fiscal commitment on fiscal commitment by the government is not a risk-free option. The British government has limited fiscal spare capacity. Among the larger European countries, the UK government’s exposure, formal or implicit, to its banking sector is by far the highest. Switzerland, Denmark and Sweden are in a similar pickle, with the banking sector solvency gap threatening to become larger than the fiscal spare capacity of the state.

The British government should go easy on the discretionary fiscal stimulus it applies, lest it risk a triple bank, sterling and public debt crisis. Better to first let the Bank of England use the 300 basis points worth of Bank Rate cuts that it still can play with. Even better to combine rate cuts with measures to directly target the disfunctionalities in the interbank market, such as government guarantees for (cross-border) interbank lending.

The UK shares with the United States of America the predicament that unfavourable fiscal circumstances make the wisdom of a significant fiscal stimulus questionable. In the US as in the UK the twin deficits (government and current account) severely constrain the government’s fiscal elbow room. Both countries need all the help they can get from fiscal stimuli abroad, in China, in Germany and in the Gulf. Beggars can’t be choosers.