Over the course of the third quarter of this year, the impact of the financial tsunami which hit the global economy in 2008 has appeared to stabilise. Banks whose balance sheets have been severely damaged by the crisis have been forcibly merged, restructured or taken into public ownership. The single major player- Lehman- that went under caused so much damage that policy makers have vowed not to repeat that mistake. As banks struggled to retrench without increasing the global problems, the monetary authorities released huge amounts of liquidity. The result has been a rally in asset prices as the availability of credit, while not at the levels of 2007, is at least more predictable.
However, by taking on so much extra debt onto government books, the problem has not been diminished, but only moved around. Whereas the shareholders of banks had been looking at taking the impact of large loan losses, their place has been taken by tax payers. In some cases, this has been a great success: tax payers have even made a profit from the disposal of their interests in such firms as Goldman Sachs, for example. However, there is still a huge amount of work to do before the work-out of the damaged banks can be completed.
Unfortunately, governments are now facing a new pressure: there is a limit to the scale of borrowing that they can undertake before the market will demand a higher price to reflect the increasing risks, or even cease to supply credit to a risk that it considers unacceptable. Historically banking crises do lead to sovereign debt crises and we now appear to be seeing the global credit crisis about to take on a new character. The emergency credit standstill demanded by the state corporations of Dubai does not in itself cover a particularly large amount of money. However, it is a signal that the crisis is now moving into a new phase where government action is coming under considerable scrutiny from the markets.
As I discussed on BBC news this morning, questions are now being asked of countries like Greece which has a stubbornly high government deficit and seems to lack the political will to deal with its problems. That Greece is also exposed to the property markets of Bulgaria, through the lending of its major banks, is simply another point of concern. Greek government debt is high and its deficit is unsustainable in the long term. Nevertheless the country has the breathing space provided by its membership of the Eurozone, which is why the country has not had the same mark down as, for example Hungary, which remains outwith the single currency. However one of the primary moves last week was a significant increase in the risk premium that investors want in order to hold onto Greek government paper. Euro membership can only provide a breathing space, and the newly installed Greek government will not have long to offer a credible programme to bring its finances into line.
However what should appal people in Britain is the inexorable rise in the profile of the problems of the UK. Goldman Sachs continues to publish reassuring research papers on the British economy, but a cynic might ask "cui bono?" given the close relationship between that finance house and the work they are undertaking with the British government. Today's research paper by Morgan Stanley comes as a strong antidote to such reassurance. Indeed it comes as a bucket of cold water in the face to the more rosy scenarios of British recovery.
In short Morgan Stanley suggests that the UK is out of rope in terms of its ability to continue to raise further money in international markets, and the prized AAA credit rating is now at serious risk of downgrade, with the substantial increase in borrowing costs that this would trigger. The near doubling of the national debt over the past 18 months and an unsustainable deficit, which at 14% is 2% higher than Greece, can no longer be regarded as a credible policy mix. The UK is going to have to budget to take a serious hit from write-offs in the banking sector.
2010 is an election year and the fact is increasingly clear that any incoming government is going to have to take emergency action to reduce the government deficit. Not only must tax revenues increase, but government expenditure must be slashed. The choices that will now have to be made are truly agonising.
As the attention of the global markets moves from the failure of banks towards the financial capacity of those that back them, the United Kingdom is coming into the firing line. The next six months could be very uncomfortable indeed.