While attention was last week focused on the crisis surrounding News Corp, another crisis was slowly burning away elsewhere in Europe. Italy was facing a sovereign debt crisis. The shockwaves of the financial crisis continue to reverberate. There are lessons here for the UK and for Labour.
The catalyst was Silvio Berlusconi. The Italian premier criticised his well respected finance minister as the country considered budget cuts. Market attention had been focused on so-called peripheral countries in the Eurozone – Greece, Portugal, and Ireland, as well as on Spain. Now crosshairs have also focused on Italy. The yield on Italian government debt jumped last week – in other words, Italian government bond prices fell. The government sold tranches of new debt, but at higher interest rates. The prospect loomed of a downward spiral in which higher costing debt required more debt to be issued, so driving up the cost further.
Why did this happen to Italy? It is a much larger economy than Greece and it has a primary surplus outgoings. However, Italy’s public debt is 120 per cent of its GDP and the GDP growth rate is relatively low. In a quieter time in British politics we would expect George Osborne to be claiming loudly that Italy’s travails demonstrated that his spending cuts are justified, as he has done over Greece.
There are key differences between the UK and Italy. One is that the UK is outside the euro; the UK could ultimately print money so it will always pay back its debt (at a risk of higher inflation). Our net debt-GDP ratio, while high by our recent standards, is only expected to peak around 70 per cent, which is well below Italy’s. The average maturity of our government debt, at 14 years, is almost twice that of Italy. Another difference is that the UK does have a plan to bring debt down. We might not like the plan, believing it risks growth and cuts spending too far and too fast, but to the world at large this country at least has a plan that it has embarked upon.
The risks to the UK include lower than expected GDP growth, leading to lower tax receipts and hence lower public debt reduction (and a debt-GDP ratio that is higher for longer). This is what the sharp spending cuts may bring to pass. The market debate about Italy has included comment on its growth outlook. Where a country has a high debt level but poor growth outlook, the bond markets can take fright. That is why a government needs not only a credible plan to reduce public debt to manageable levels, but also a clear idea of how growth will be encouraged. This is lacking under our Tory-Liberal Democrat government.
Stephen Beer is an investment manager at the Central Finance Board of the Methodist Church. He is chair of Vauxhall CLP and the Christian Socialist Movement’s political communications officer. This article represents his personal opinion. www.stephenbeer.com
Re-instatement of comment posted on 19 July 2011, 10:49:41 PM (paragraphs restored)
Italy’s plight (added to that of Ireland, Greece and Portugal) highlights the dire state of European (and world) financial markets. The mess has resulted from the lack of the right sort of control at an international level.
The growth of credit in recent years has been the prime mover of increases in GDP and property prices, useless takeover activity, top management bonuses (indirectly), and all the rest.
The founders of the Euro must have been keeping their fingers crossed when they set it up. It is clear now that they were unaware that the banks in their region would be swamped by inter-bank money originating from outside the region, money arising from both reputable and disreputable sources. The banks have also been swamped by the fancy inventions of the financial engineers.
The banks’ vulnerability has resulted from group-think in supposedly competitive markets with their speculative activities protected in the name of “free markets”. It may be that the EU will be able to muddle through, but it may have to set itself up as a lender of last resort to an unlimited extent to support all borrowers and to prop up asset prices in the Euro-region. We’re not there yet. Not yet.
However, the terms of the provision of credit need a fundamental re-think. Investment, in principle, even by governments, should be provided by equity-type finance. [Incidentally, UK government (whichever one) push for banks to lend to small business is mis-guided. Such businesses need equity-type finance, not lending.] Loan finance should not be used other than for the shortest-term bridging. It is the job of bankers to fudge these principles and they have, in recent years, done so with increasing ingenuity. Now is time to limit this ingenuity.
There are lots of things now being discussed by EU leaders about bank capital ratios and so on, but they miss the point to a large extent. What is needed is to tackle the problem from the bottom up by restraint on the terms on which the banks do individual pieces of business.
Here is but one example of what could be done. In some oil and extractive industry financings, loans have been provided with Force Majeure clauses. In other words, if the borrower cannot repay because of some unforeseen circumstance, that is hard luck on the lender and the terms of the loan are amended to what the borrower can afford. The lenders have to wait, take a “hair-cut”, accept reduced interest, or whatever, as part of their contract.
A Force Majeure clause could and, I think, should be included, or imputed as a matter of law, in all lending instruments. The adoption of this idea generally would not solve today’s problems immediately, unless it were done retrospectively, but it would change the balance of power between lender and borrower. This is one proposal designed to lead to greater financial stability.
In fact, were everybody to be honest, they would find that the banks were already all unable to meet their commitments without government or European Central Bank support. Were that support to be withdrawn, they would be trading insolvently, a serious offence under English law. In that case, their equity would most likely be worthless and there is an argument for complete nationalisation, free of payment to shareholders.
Such a situation would enable governments to re-make the banking system so that it did not consist of a set of giant vampire squids, but of entities that were the servant, rather than the master, of the real economy.