UK financial system at risk of systemic crisis
In a recent paper, “How serious a threat is the UK’s financialised economy”, published by the Jimmy Reid Foundation, and available on the Reid Foundation website, I analyse the stability of the UK economy. The paper concludes that there is a serious threat of a renewed economic crisis. This is not just worrying in its own right: it also has important implications for the Scottish referendum debate.
The 2008 crisis in the financial system brought the world’s economic order to the brink of imminent collapse. The implications for the UK were particularly serious, given the dominance, unique among major economies, of the financial sector in the UK economy. This then raises a vitally important question: have the risks posed to the UK economy by the financial sector gone away, or is the UK still at serious risk of another crisis?
The approach adopted in the paper is to examine the balance sheet of the UK – that is, the total of the assets and liabilities owned, and owed, by the different agents in the economy – breaking the balance sheet down by the different sectors of the economy. What emerges is a very worrying picture. The problems, at root, relate to the UK’s massively overblown financial sector. In proportionate terms, the UK has a larger financial sector than any other major economy: by 2008, the size of the financial sector, measured in terms of its total assets, (or liabilities), was about 16 times UK GDP: and it has hardly shrunk since 2008, still standing at around 14 times GDP.
The sources of instability which posed the threat in 2008 have not been addressed: the idea that these problems arose because we had individual institutions which were too big to fail is too simplistic – our problem now is that we have a financial sector which in itself is too big and inter-connected to fail. In addition, further sources of potential instability have emerged since 2008: the response of policy makers to the threatened collapse of the 2008 asset bubble was to prop up asset prices by low interest rates, and quantitative easing, hence inflating an unprecedented bond bubble. And the potential liabilities associated with financial derivative products grew hugely in 2008, and now stand at some 400% of GDP.
Moreover, policy makers are still repeating earlier mistakes: witness the way policy has deliberately stoked up a new housing bubble, with house prices now above their 2008 level, and increasing at about 10% per annum.
As well as looking at the financial sector in detail, the paper also considers each of the other sectors of the economy. As the paper shows, each of these non-financial sectors has been seriously weakened, either by the run up to the 2008 crisis, or the policy actions which have been taken since 2008. In the household sector, the renewed housing bubble has pushed house prices way out of line with a sustainable relationship to earnings. In the non-financial corporate sector, there are chronic problems with low productivity, and, according to one study, there are over 100 thousand underperforming companies which cannot fully service their debts. The public sector is burdened with a level of net debt which is more than twice what it was prior to 2008, and net debt is still growing. And in international terms, the UK’s chronic deficit on its current account now stands at an almost unprecedented 3.8% of GDP.
What this means is that the rest of the economy is in no position to bail out the financial sector should there be another financial crisis. And yet, the financial system is just one shock away from a further crisis – because the fundamental issues of 2008 were never addressed, and, specifically, because of the unstable asset bubble blown up by quantitative easing, particularly in government bonds. No less a person than Andy Haldane, Director of financial stability at the Bank of England, identified this as the biggest threat to global financial stability when he gave evidence to the Treasury Select Committee in June 2013: in his words:
“If I were to single out what for me would be the biggest risk to global financial stability just now it would be a disorderly reversion in the yields of government bonds globally….Let’s be clear, we have intentionally blown up the biggest bond bubble in history.”
Basically, any shock, (like a significant rise in interest rates), which led to a sharp fall in bond or asset prices could lead to a downward spiral of credit contraction, loan defaults, and further asset price falls – with disastrous consequences for the real economy. And there are any number of potential triggers which could provide such a shock: for example the theory of quantitative easing states that the process will in due course be reversed, and that the authorities will start to sell back into the market the £375 billion of government bonds which the Bank of England bought with the money it printed. Unless this process is handled with extreme care, there is a real danger that this could result in a sharp fall in bond prices, (which is equivalent to a sharp rise in interest rates).
Another reason the price of government bonds might fall is if investors rediscovered a more normal appetite for risk, and were no longer willing to hold government bonds at very low rates of return as a safe haven.
Or a recovery in the US economy could prompt a rise in interest rates there, so forcing the UK to raise interest rates to prevent an outflow of capital.
Or there is the risk of a shock to some specific class of assets: e.g., a widespread default on Chinese securities, or on European bonds.
Or the bursting of the domestic housing bubble, or of default on non-performing commercial real estate loans.
Or adverse political events internationally: e.g., a worsening of the crises in Ukraine or the Middle East.
And let’s not forget domestic political events: e.g., market jitters caused by the “wrong” outcome to the Scottish referendum, or the imminence of a domestic UK referendum on EU membership.
Overall, the unstable position the UK is in, and the likelihood of a future shock, mean that there must be a serious risk of the occurrence of a systemic crisis in the UK financial sector, and wider economy, in the near future.
The paper is about the UK economy: but it is very relevant to the forthcoming Scottish referendum. At the core of the referendum debate should be the question of relative risk: what are the risks of Scotland going it alone, compared with the risks of staying in the UK? Unfortunately, the debate has not been conducted in a balanced fashion: instead, too little attention has been paid to possible systemic risks facing the UK economy. This is understandable as regards the “no” side in the debate – who will naturally portray the UK as a bastion of economic stability. But the failure by the “yes” campaign to address the risks attaching to the UK is much less understandable. The dangers to the UK economy highlighted in this paper make it essential that in the referendum debate much more attention is paid to these risks.