"In an earlier post to this blog, I raised the possibility that the UK might face a triple financial crisis: a combined banking crisis, sovereign debt crisis and sterling crisis. Let me be clearer than I was before about what I mean by a financial crisis. A financial crisis is a situation where quantity rationing of would-be borrowers and would-be sellers of securities suddenly replaces normal market clearing through variations in interest rates or market prices of securities. So a sterling crisis does not require a fixed or managed exchange rate regime for sterling. It can occur even when sterling floats, that is, when its external value is market-determined, as it is today."
Please read all of it. It's an education. But, I don't know what's going on in this blog now, but the comments are excellent. It provoked this response:
"According to Professor Buiter, last week’s fall in sterling is symptomatic of a “triple crisis” — a simultaneous loss of confidence in the currency, in the banking system and in the Government’s fiscal solvency - that could threaten Britain with an Icelandic-style collapse; this crisis is the price that Britain, like Iceland, is now paying for its stubborn refusal to join the eurozone. Professor Buiter’s analysis is obviously more sophisticated than George Osborne’s, but rests on the same fundamental arguments: first, that Britain, like Iceland, is a “small economy” that does not have the privilege of using a “reserve currency”, such as the dollar and the euro. Second, that Britain’s banking sector, like Iceland’s, is so big that government banking guarantees endanger the country’s long-term fiscal solvency.
I see these arguments as fallacious - and, much more importantly, so do the Government and present members of the MPC. There are many objections to the Buiter argument, but the main one is simply that in the modern world of paper money and floating exchange rates, there is no such thing as a “reserve currency” - only different currencies that are traded and used as stores of value in the same way as other as assets. Investors cannot sell one currency, such as sterling, without buying another, be it the dollar, euro, yen or Swiss franc. The attractiveness of these alternative currencies depends on a host of factors, above all the return on assets in the country concerned, the inflation outlook, the degree of protection for property rights and the tax and legal systems. The level of government borrowing is only one consideration in investment judgments about a currency - and a very minor one, as evidenced by the strength of the yen despite the Japanese Government’s enormous debts. The size of the banking system relative to national income is even less important, as demonstrated by the strength of the swiss franc.
The upshot is that, far from being feared as a “punishment” for Britain’s monetary independence or long-term fiscal profligacy, the present fall in the pound should be seen as part of the solution to Britain’s economic problems. As Mervyn King noted at his press conference last week, the UK needs to revive economic activity and avert deflation, but also to restructure its economy to reduce dependence on consumer spending and housing. It would also be helpful to reduce the country’s reliance on foreign capital inflows. What all these requirements mean, as a matter of simple arithmetic, is that the structure of Britain’s trade must shift substantially, to the point where exports either exceed imports or the remaining trade deficit is matched by inflows of capital from foreigners investing in UK property, businesses and other assets, in the expectation of better returns than they can earn elsewhere, either from higher return on capital or a future rise in sterling.
The textbook way to achieve such a shift in foreign trade and capital inflows is to combine bold cuts in interest rates, which lead to a sharp, though usually temporary, currency devaluation, with a squeeze on consumer demand. This was precisely the combination that worked so well for Britain in the 1990s after the Treasury’s age-old fixation with trying to stabilise or manage sterling was abandoned once and for all.
Britain’s aggressive use of monetary policy leads to two obvious conclusions — and one less clear. The first obvious conclusion is that the “collapse” of sterling will not discourage the MPC from continuing to cut interest rates. Most MPC members see sterling’s decline as a welcome side-effect of lower rates and a helpful transmission mechanism from monetary easing to the real economy at a time when credit markets remain paralysed. Mr King has now publicly confirmed what I said here last month - that bank rate could easily fall to previously unthinkable levels as low as 1 per cent. The second obvious conclusion is that the present currency weakness, far from reopening a debate in Britain about joining the euro, should be seen as a vindication of the decision to keep an independent monetary policy and a floating currency.
The less obvious issue is whether the pound will continue to weaken against the euro, as the MPC moves farther ahead of the ECB in the cycle of monetary easing and the Government stimulates the economy by cutting taxes. With Euroland now in deep recession and the pound back to the low that triggered a strong economic rebound in 1995, market sentiment may well swing against the euro and in favour of sterling as investors conclude that eurozone policymakers are doing too little, too late, while Mr Brown and the MPC are laying the foundations for economic recovery in Britain.
Posted by: Anatole Kaletsky, The Times | November 17th, 2008 at 5:36 pm | Report this comment"I wanted to keep this exchange. Here's my comment, which focused on what my limited abilities could:
“The problem with nationalisation of the banks is that when the state owns a bank and the bank goes broke, if the state does not make all creditors whole (ensures that their claims are met in full), a bank default becomes effectively a sovereign default. To avoid that, it is essential that banks be put into some form of receivership before the state takes a controlling ownership stake in them. When the bank is in receivership, all holders of the bank?s unsecured debt, even the senior debt holders, and all other creditors, including unsecured senior creditors, can be made to pay a charge (suffer a haircut).”
The state as the barber of last resort. I agree with this, purely as a moral point. You seem to say so here:
“The alternative is that the tax payers or the current beneficiaries of public spending compensate in full the holders of unsecured bank debt and the banks? other unsecured creditors. That would be outrageously unfair. It would also constitute the mother of all moral hazard. The creditors of the bank and the holders of the unsecured debt were essential participants in the process that created the excessive leverage taken on by the banks. There can be no reckless lending and investment by banks unless the banks have reckless creditors and reckless purchasers of their debt. These creditors and debt holders must be made to suffer financial losses if we are not to encourage even more reckless lending and investment in the future.”
This seems like a workable set of principles of how the government should approach this current crisis, and I would like my government to subscribe to them as well.The problem with my government is that they’re afraid to trim too much off the top, when they should be willing to leave these bankers and others bald like me. I believe that it’s called a buzz cut.
Posted by: Don the libertarian Democrat | November 17th, 2008 at 6:40 am |
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