We need to talk about Europe

In the run-up to the last election, much was made of the UK’s poor financial situation. We were told repeatedly  by the Conservatives that after years of irresponsible borrowing, our finances were the worst in the developed world, that we were on the point of bankruptcy and that if we didn’t immediately reduce the deficit then no one would lend to us.

18 months on, we’ve achieved nigh on no economic growth and despite the government’s cuts have continued to increase our debt at more or less the same rate.

This leads me to wonder – if our finances were so bad then and have got worse since, why is it that we can continue to borrow money so cheaply when no one will lend two Drachmas to all of those struggling economies in the Eurozone? Something doesn’t add up.

First, let’s look at whether our finances were really the worst in the developed world. This is a graph of government debt as a percentage of GDP for each country in the G7. The data is taken from the IMF website.

Government Debt as a Percentage of GDP (source IMF)

Government Debt as a Percentage of GDP (source IMF)

You see that orange line at the bottom? That’s the UK. Were we really borrowing so irresponsibly for all of those years under Labour? That’s a matter of opinion but if we’re on the naughty step then it’s pretty crowded.

On a side-note, Japan’s is quite impressive, isn’t it? They seem to be in a Ponzi scheme with their own public but Japan could be a million blog posts on its own so I’m not going down that avenue.

Turning our attention to the Eurozone, you will have noticed in recent weeks that Angela Merkel has blamed the current crisis on the irresponsible fiscal policy of certain member nations – i.e. that they have screwed the Euro by living beyond their means.

Here’s some more data from the IMF website showing some Eurozone economies’ borrowing as a proportion of GDP from the adoption of the Euro up until 2007, the year before the financial crisis.

Government debt as a percentage of GDP (Source IMF)

Government debt as a percentage of GDP (Source IMF)

Ireland and Spain reduced their debt significantly in this period. Italy reduced theirs a bit and although it was pretty awful in 2007, it was even worse when they joined the Euro so I don’t understand the sudden surprise now.

Anyway, it’s fairly clear that while Italy and Greece maintained high levels of borrowing throughout this period, Ireland and Spain did not. Merkel’s claim that each of these nations brought it on themselves purely through their government borrowing is not backed up by the figures. Ireland arrived on the eve of the financial crisis with much lower borrowing rates than they’d had historically but their economy imploded spectacularly nonetheless. Saying that the problems are purely down to fiscal policy is quite bizarre.

Another factor, which Merkel hasn’t wanted to mention, is monetary policy. In the UK when our economy got into difficulty the Bank of England cut interest rates and they have been sitting at a tiny 0.5% for the last two and a half years. Conversely, in April, egged on by Germany, the European Central Bank started to increase interest rates in the Eurozone and perhaps it should not come as a surprise that this coincided with the start of the current crisis.

The fragile Eurozone economies didn’t want higher interest rates but they could do nothing about it. Germany wanted higher interest rates because they were worried about inflation and so the weaker economies had to pay for this through lower growth and higher unemployment.

When the fragile Eurozone economies want to borrow money, lenders look at them and see that they are powerless to control this basic facet of monetary policy and therefore have lower confidence in their ability to respond to changes in their economies. If I want to invest some money shall I do it with a country who can respond to economic problems or one who can’t? Not a difficult decision.

There is though, another branch of monetary policy that is perhaps even more concerning. There is a reason that no one in the market really worries about the UK or the US being able to repay its debt but do worry about the economies in the Eurozone.

If the UK ever gets into a real pickle and needs some more Pounds to repay a loan they always have the option of going to the printer and just printing it. The UK controls its own currency. Ireland doesn’t. Italy doesn’t. Spain doesn’t. If they run out of money they go bust.

In the first recession they have faced, the Eurozone members’ lack of control over their own monetary policy has been a key factor in the crippling of several economies. Angela Merkel now wants to take things further and take away their control over their fiscal policy. Forcing the weak economies into crazy austerity measures will simply lead to many more years of high unemployment and no economic growth.

If it’s that simple though, why would Merkel be advocating a clearly bad policy? The problem Merkel has is that if she did the sensible thing and told the ECB to cut interest rates and buy up lots of government bonds from the weak economies, the German people would get cross and she would not be re-elected. Sadly, these are the things that matter most to politicians.

So what will actually happen? This is my prediction:

  • Germany will implement some rules to restrict fiscal policy of the Euro member states which will keep German voters happy but screw up the weak economies for years to come
  • Having done this Germany will then, finally, allow the ECB to buy up some government bonds, allowing the fragile economies breathing space to avoid short term default
  • The underlying problems will remain

Do you remember when William Hague fought his 2001 election campaign with pretty much one policy? “Keep the Pound,” he bleated incessantly for several months before losing in a landslide against a government who, err, kept the Pound.

He was right to want to keep the Pound though. Ok, he was right for the wrong reasons – nationalism and xenophobia have little place in macroeconomics but in hindsight, I shudder at the thought of where we would be now if we’d adopted the Euro too.

There is a certain romance in the single currency. It feels like it brings us all closer together, working with our neighbours in one financial union and it’s a marvellous two-fingered salute to the sickening xenophobia peddled by Nigel Farage and The Daily Mail.

Sadly, romance and economics don’t mix either and whatever transpires, one thing is abundantly clear – in an era of many bad ideas, the worst one of all was the Euro itself.



Debt, Deficit, Default and Bugatti Veyrons

The other day @WH1SKS tried to bully me into writing a blog post. Normally I don’t give
in to cyber-terrorism but he has big muscles and he could snap me like a twig so I’ve broken the rules a bit.

I have forgotten exactly what the brief said but I think it was something like, “what would happen if the US and Europe didn’t repay their debt?” I couldn’t write it at the time as I had a hangover (because I am cool.)

I don’t have a hangover at the moment (I am still cool though) so I’ve briefly written down my thoughts. I should state that I don’t really know much about this and wouldn’t even have attempted it if @WH1SKS hadn’t made me, so it might be nonsense – these are really just my uneducated thoughts. I do think the US and Europe are very different though so I will look at each in turn….

The United States

The USA has about $14.6 trillion of debt. A number like that is impossible for the brain to comprehend so I’ll tell you what it looks like. The world’s most expensive road car is the Bugatti Veyron Super Sport (BVSS), which costs $2.4m and is 1.19m tall (that’s about $2,000 per millimetre). If you bought $14.6 trillion of BVSSs and stacked them on top of each other they would form a tower 818 times the height of Mount Everest.

(If you then drove them all forwards at the same time the one on top would probably achieve 30 or 40 million miles per hour which would be pretty cool. Still, it would almost certainly end in a nasty accident, so please don’t try this.)

I’ve forgotten my point. Oh, yes. The amount of money they owe is very big. So what would happen if they decided not to pay it back?

Firstly, the US would find it pretty tricky to borrow any money ever again because no one would trust them. You might wonder why this is a problem – they just became better off by $14.6 trillion so who cares? It’s a problem because even with the debt cleared off they would still have the deficit. The deficit is the amount by which their spending exceeds their income and last year the US added 95 Mount Everests worth of BVSSs onto their pile of debt. This means that if no one would lend them any money any more they couldn’t finance their deficit and would therefore need to take immediate action to make the books balance. You are all aware of Labour’s “too much too soon” argument against Conservative spending cuts. Labour’s position is that we are trying to reduce our deficit too quickly and by doing so harming economic growth thus costing us more overall.

When considering the size of the cuts being implemented by the Conservatives this point is debatable. But the Conservatives are not proposing to eradicate the deficit overnight or anything even close.

In our fictional scenario, the US would need to reduce it by 100% with immediate effect. They could do this by massively reducing spending or massively increasing taxes. Either way this would send their economy into a devastating recession, 100 times worse than the last one and they wouldn’t come out of it for a long time. Because the US is so important in the global economy we’d all be back in recession too and again it would be much worse than the last one.

So although paying back 818 Mount Everests of BVSSs it not pleasant it is actually much better than the alternative, so we could therefore say that if a country can pay off their debt then they will do. And in reality the US can afford its debt at the moment without any major risks. It’s a lot of debt but it is a very large economy and the markets are happy to lend it a lot more before they start to worry about its solvency. What the markets were concerned about (and what led to the S&P downgrade) was more a plausible situation in which the US made some interest payments late because its politicians were too incompetent to govern the country properly. The effects of this would have been far less severe than the situation described above where the US outright could not repay any of its debt.

That said it would still cause a major problem. Lenders would be much more nervous about lending going forward, so would require a higher interest rate to compensate for this. More expensive borrowing would slow down the US’s recovery further that alone might not actually be much a disaster were it not for the fact that markets always over-react to everything. The markets would see late payment as bad news and when bad news happens, people in the financial sector all turn into Beaker from the muppets and panic and make everything a thousand times worse.

A banker dealing with bad news
A banker dealing with bad news

So yes, it would be bad for the US to miss a payment but maybe the biggest problems would be caused indirectly by the market’s reaction, rather than from the direct problems of the person who didn’t receive the cash.

That’s America. Let’s move on….


Everyone has been talking about Greece. Greece’s situation is, I think, a lot worse than what’s going on in the US. Greece’s debt is only (!?) 19 Mount Everests of BVSSs but its economy is tiny in comparison with that of the US and there is a very real possibility of Greece not being able to make its debt repayments. The market realises this and unlike the US no one really wants to lend Greece any more money. This is why they are continually asking for bailouts to keep things going.

If Greece defaults on its debt then it will have serious implications for the rest of Europe. The Greek banks would all fail overnight but it’s worse than that. Most of the major European financial institutions have also lent a lot of money to Greece and some of them will most likely be in trouble. As we saw in 2008 when Lehman’s went bust, a major default causes the banks to completely lose trust in each other. As soon as they lose trust in each other, interbank lending stops and then they get into even more trouble:

  • Bank#1 needs to borrow some money from Bank#2 to pay back a loan to Bank#3.
  • Bank#2 has the cash available but doesn’t know if Bank#1 is ok or not so won’t lend it any money.
  • Bank#1 therefore can’t pay #Bank3
  • Bank#1 goes bust
  • Bank#3 didn’t receive their cash! Are they in trouble now too?
  • No one lends to Bank#3
  • etc etc etc

The other very shaky economies, Portugal, Spain, Ireland and Italy would be hit quickly afterwards because no one is going to risk pumping further money in there.

The European Central Bank would effectively be left holding the bomb when the ticking stopped and would only be able to stop those countries collapsing by printing lots of money (thus screwing the Euro) or by taking significant funding from the more healthy economies (Germany and France) which would screw them up quite a lot too.

The UK would probably be happy that it didn’t join the Euro but its banks would be severely hit and additionally, the EU is the UK’s biggest trading partner, so the UK economy would take a big hit too. I have no idea by how much but it wouldn’t be good.

Markets would react by everyone turning into Beaker from the muppets again.

So, in summary, I think the US is actually ok financially and its problems are caused more by its crazy politicians than by its debt. I am much more worried by Greece, Portugal, Ireland, Spain and Italy, a situation where there I think there is a significant risk of a second global financial crisis.

And if that happens we are not all going to be driving Bugatti Veyron Super Sports any time soon.