The fundamental, and at times, passionate debate about sovereign debt is a predictable part of the sequencing of the financial crisis rumbling through the West. The crisis has exposed three major fault lines in our fiscal systems. First, it broke the banking system, the fixing of which has extracted a heavy cost. Second, it shocked western economies, depriving governments of significant tax revenues. Third, it exposed the fragility and unsustainability of public finance arrangements, by reminding us of the existing and enormous future budgetary costs associated with rapid ageing. It is no accident that the sovereign debt crisis has come to roost in four OECD economies facing the largest expansion of age-related spending: Greece, Portugal, Ireland and Spain.
These three fault lines are structural problems that require structural solutions. The banking system won’t mend without structural change in the financial services industry. A significant portion of the tax revenues won’t come back, without finding new sources of economic growth. And the fiscal consequences of ageing cannot be sustained without reforming labour markets and pension systems.
In the euro area, you might also argue that the sovereign debt problem in the ‘Med’ countries cannot be resolved without addressing the structural integrity of the euro. This agenda goes much further than the provision of temporary financial assistance to Greece, and embraces both the lack of fiscal transfer mechanisms, and the willingness of Germany, as Europe’s major creditor, to keep writing cheques to sovereign invalids in the euro family. A mooted financial aid programme for Greece has sidelined perceived default risks for now, but the bigger agenda won’t go away.
Financial markets don’t articulate clearly to the public why they ‘pick on’ Greece, or the UK, or others. They are astute, though, in highlighting clearly a discomfort when policy inertia takes precedence over policy imagination and commitment. Accordingly, it was no surprise that sterling and the Gilt market recently wobbled, especially in the wake of opinion polls pointing to the possibility of a hung parliament. There is no public debt crisis, per se, at this time but market angst is likely to linger until either the polls shift again to indicate a greater chance of one party emerging with a clear majority in the House of Commons, or indeed until the outcome of the election itself. Markets cannot know for sure, but they could be forgiven for assuming that an indecisive result could lead to a fractious and protracted period of uncertainty, just when clear and assertive leadership is required.
The clear and detailed programme for restoring fiscal stability that everyone seems to believe is necessary wouldn’t happen. The credit rating agencies would take a dim view, and investors might not wait for sterling to fall, or have their hands forced about whether they could hold downgraded securities. The decline in sterling and Gilt prices might then become more turbulent, in the end forcing the authorities into a fiscal retrenchment at a time and on a scale that was of no one’s choosing.
The hung parliament angst has displaced, for now, another contentious economic policy issue that is steaming in the UK. The argument has become heavily politicised, but the economics is about when and how to proceed with fiscal retrenchment, specifically in a debt and deleveraging crisis. It is due to start in the fiscal year starting in April, but the question is how to embrace public frugality without succumbing to private economic anorexia? Financial markets, investors and the rating agencies could hardly hold their fire if they expected a new cycle of recession and higher public borrowing. But the chances are that markets would welcome a clear and detailed programme that indicated how fiscal austerity would be phased, and two ways in which the economy’s structural settings would be re-booted: one to substitute employment-generative capital spending programmes for some current public spending, and the other, to boost employment rates and working lives for older workers, and skill formation for younger ones.
With just over two months to go to the election, then, have we just witnessed the start of the countdown to sterling parity against both the US dollar and the debt-compromised euro, along with adverse effects on gilt yields, and a contagion to US dollar markets? I would guess probably not but the relative tolerance in financial markets has limits. The acid test for financial stability in the UK, as elsewhere, is whether the political system can deliver economic leadership and imagination, and social and political institutions are up to the task of following. Brits can take some comfort in the latter, but the former will remain a known unknown for a while yet.
George Magnus is Senior Economic Adviser at UBS Investment Bank and author of The Age of Aging. Commercial Loan Workout.
Tags: banking system, borrowing, debt crisis, economic growth, financial crisis
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