If there is doubt in the markets about whether the solvency gap of the banking system is smaller than the fiscal spare capacity of the government, we could have a UK public debt crisis. Fear of default would cause an across-the-board rush of out sterling assets. Fear that the authorities would choose to monetise the UK public debt and deficits rather than defaulting, would also cause a sharp decline in the value of sterling.
There are fiscal limits to what governments can do, and pledging to bail out all investors who have claims on the financial system is not the same as being able to actually carry out this pledge. Moreover, a run on sterling would not only signal the failure of the British bailout plan; it would set in motion currency shockwaves that would ricochet through the global economy. Money fleeing the pound would have to go somewhere else, but this somewhere would then find itself on a hair trigger, as fears of currency and default risk escalate. My reference period for the earlier Depression is not 1929, for which there were domestic solutions, but 1931-32, when a cascade of currency runs rendered national monetary policymakers helpless.
Having signed on to Buiter’s main point, I want to emphasize some divergences:
1. Britain’s risk is, like Iceland’s, a function of the size of its banking sector liabilities relative to the economic size of its currency area. It can crank up the denominator by joining the eurozone—if it can. The political impediments in this environment are simply too great, however. If Britain starts to melt, would the euro powers risk their own solvency to save it?
2. The US has a far larger GDP, but its numerator is also much larger, since the epicenter of the crisis was in US-generated assets, all of which matter because the Fed has committed itself to making good on all claims on US financial institutions, whatever their country of origin.
3. The dollar is a reserve currency as the pound is not. This gives the US much more breathing space, and the amount of claims needing to be satisfied would not be altered by a potential devaluation, since it’s all in dollars. What this means, though, is simply that the dollar can hold on longer than the pound; it doesn’t mean the dollar is invincible. It is ultimately subject to the same constraints laid out in Buiter’s analysis (and mine).
4. The British exposure is somewhat less than meets the eye. The City is the repository for an undisclosed but certainly very substantial pool of mideast petro-profits. Their placement is essentially a political, not a market-based choice. No doubt the failed occupation of Iraq has reduced the geopolitical subservience of the Gulf potentates, but it is hard to believe that they would simply withdraw their funds in a crisis. They remain vulnerable domestically—even more so as oil prices fall—and still depend on Anglo-Saxon guarantees of their continued rule.
5. Buiter’s solution, to move first on trimming the claims (haircuts) before assuming public liability for them, is entirely sensible, and roughly equivalent to the asset window I briefly described in my own proposal two months ago. The problem is that he gives no attention to the collapse of the real economy. In fact, he would exacerbate it by cutting back fiscal stimulus, which he sees as unaffordable. Here I think he misses perhaps the most important point: that a principle reason for reversing the bailout strategy is to have the resources to sustain employment and income. Moreover, the finance for renewed growth is essential, and if the strict austerity Buiter (rightly) seeks to impose on financial markets only dulls the private appetite for assuming new risk, a public financial entity must pick up the slack.