How bad is the sovereign debt crisis going to get? On the surface, the rising tide of government borrowing needn’t necessarily be catastrophic. After all, even with epic, Gordon Brown-style mismanagement, it’s pretty hard for governments to go bust: they can always just raise taxes to pay off their debts. And Keynesian economists tell us cheerfully that all the money spent on ‘stimulus packages’ will make the economy grow faster, and so pay for itself in higher tax revenues. But, just like the subprime mortgage meltdown, three factors have the potential to turn this from a serious but containable problem into a full-scale crisis.
The first is contagion. The subprime crisis started with trouble in the housing market. By itself, not a huge problem. It didn’t end there, however. It quickly spilled over into the bond markets, the derivatives markets and, finally, the banking system, until it had become a full-scale financial crash. The same is happening with sovereign debt. Trouble may have flared up in Greece, but attention has quickly turned to the other so-called PIGS: Portugal, Italy, Ireland and Spain. Now it is shifting to Britain. Yields on UK government debt are already higher than in Spain or Italy, an unprecedented humiliation (Italy, after all, always used to be a by-word for fiscal irresponsibility). Soon, markets will turn on Japan and America. The problem just spreads and spreads.
The second is greed. The financial markets have got used to a succession of free lunches. Banks invested in bonds issued by Greece, Portugal, and Spain, even as those countries racked up huge debts. Investors simply assumed they were just as safe as paper backed by the German or French government. They thought they could pocket the extra yield, without having to shoulder any significant risk. But now that it turns out that the higher yielding assets were also riskier, the markets are clamouring for a bail-out. That’s despite the EU treaties explicitly preventing the debts of one euro member being repaid by another. Just as in the subprime crisis, the greed of many investors for higher-yielding assets led them to take too many risks. They got burnt on subprime mortgages, and now they are getting burnt on subprime sovereign debt as well.
But the most worrying common factor shared by the two crises is dishonesty. One of the main reasons the US subprime debacle turned into a global financial meltdown was the widespread fiddling of the figures. Dodgy loans to people with poor credit ratings and not much income were rolled up into complex financial instruments. These were stamped ‘triple-A’ by the ratings agencies, and then sold on to people who didn’t really understand them. In the end, no one knew who owed what to whom. So the system froze.
Exactly the same is happening with the sovereign debt crisis. We now know the figures the Greeks used to get into the euro were largely fiddled. Worse, it turns out the banks have been complicit in hiding the extent of Greek government borrowing. At least 15 securities firms, including Goldman Sachs, helped create complex ‘swap’ instruments that let the Greek government defer interest payments, so hiding yet more borrowing under the carpet. At the insistence of the Germans, the EU is now investigating.
The trouble is, that kind of creative accounting has been going on everywhere. The Italians pulled similar tricks to help massage their borrowing figures, often by swapping Italian debts into yen. And the ratings agencies have hardly covered themselves in glory. They’ve downgraded Greece, but probably not to the extent that they should. It is shocking that they haven’t downgraded Britain yet, and it is hard to believe that the only reason they haven’t is because they don’t want to offend the British government (a significant customer, let’s remember).
No one really believes that Britain is a triple-A rated borrower anymore, given the markets put a higher price on McDonald’s debt than British gilts. In this country, huge tranches of government debt have been shifted off balance sheet. The private finance initiative has become a vehicle for concealing how much the government is really borrowing. Pensions obligations are left unfunded because putting a cost on them would reveal how much the government will have to raise. That is true of other countries too. Governments aren’t levelling with their electorates or with the markets.
Above all, dishonesty is corrosive. The global banking system holds vast quantities of government paper. If it starts to suspect government debt statistics are being fudged, and the extent of indebtedness is being fiddled, suddenly no one is going to want to trade with it. By itself, the sovereign debt crisis would be a big enough problem. Fixing it would involve a lot of hard work, taking many years. Governments would have to stop throwing money at electorates like confetti. Public-sector employees would have to work harder for longer. But add in contagion, greed and dishonesty, and it has the potential to turn into a replay of the whole subprime debacle. Brace yourselves. Greece is just the start. This could soon get very nasty.