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The next financial crisis is now upon us

November 30, 2010

An abridged version of the following article appeared in this morning’s City AM. To view it, click here.

Last week a few unpalatable home truths began to become apparent to the UK political class. Nevertheless, the acute financial woes in Ireland are likely to prove a side-show to a much more serious sovereign debt crisis that threatens to engulf European financial markets in the months ahead.

Outside the single currency the UK may smugly stand, but as this drama unfolds it is clear we will be directly affected. Some 55% of our external trade is with the Eurozone and our exports are likely to become considerably less competitive as the Euro depreciates against Sterling. As William Hague never quite put it, “We are out of the Euro, but not free from the influence of the Euro”.

In truth for the financial markets the Irish crisis is now almost history. The show has now moved remorselessly on to more central players – Portugal, Belgium and Spain (the latter’s economy being four times the size of Greece, bailed out in May) and before long perhaps even to Italy (twice the size again).

For some months leading European bankers here in the City of London have been telling me of their alarm at the prospect of sovereign default by the turn of the year. Much of the debt of many struggling Eurozone countries – unlike the UK – needs refinancing over the next couple of years.

As Ireland’s economic woes became critical over the past ten days, so the recriminations have begun. The present panic, so we are told, was precipitated by the German Chancellor Angela Merkel’s unilateral announcement that bondholders should take a share of the responsibility for the costs of restructuring sovereign debt, rather than leaving it to European taxpayers, present and future. Yet to place all blame for the escalation on German shoulders is a classic example of shooting the messenger.

For without a mechanism for sovereign-debt default, investors enjoy a perverse incentive to pump ever more money into the riskiest economies. That is precisely what we have seen in Greece and Ireland. This will only stop when bondholders take an enforced haircut as part of any future financial rescue plan. The stark reality is that to date the European sovereign bailouts have been an expensive failure. By nationalising the Irish banking system, governments have across the continent protected not only depositors (unarguably essential in preserving trust in a market economy) but also corporate creditors.

At the time of the September 2008 crisis this was essentially a political gambit – much of the banks’ borrowing had been funded by institutional investors and the risk of contagion in the event of their collapse was deemed too great. Yet bondholders, as lenders of capital, are supposed to take risks (and receive ample rewards by way of interest payments). In a “heads we win, tails you lose” inversion of traditional capitalist practice when all has been turned to dust investors have expected – and continue to receive – a taxpayer funded bailout. This cannot go on. In reality if further sovereign default in the Eurozone occurs, European governments will soon no longer have either the financial capacity or political stock to let investors off the hook in this way.

The UK’s own participation in the Irish rescue is driven by a hard-nosed assessment of our own banks’ exposure to Ireland and the importance to us as an export market.

Meanwhile, Eurosceptic MPs regard the Irish bailout as the siphoning off of £7 billion of scarce UK taxpayer’s money in a misguided effort to save the Euro. In spite of all the commentary to the contrary it is probably unwise to conclude that we are witnessing the demise of the Eurozone. It is difficult to see how, outside the Euro, Greece or Ireland would ever again be able to finance their debt by selling bonds in the global capital markets. The lack of any mechanism to expel recalcitrant nations from the single currency have – and will continue to – persuade the most indebted nations simply to soak up support from the emergency fund for the European currency. Debt will only be properly priced when creditors take on some of this burden.

Moreover, the pan-European fiscal and economic squeeze designed to correct the sovereign debt crisis runs the real risk of promoting a renewed banking crisis. The truth is that in this low-to-zero interest rate environment (a deceptively benign state which provides a strong disincentive to foreclosure) many banks, both domestically and in mainland Europe, still have huge unquantifiable toxic ‘assets’ on their balance sheets. Other sovereign nations faltering would most likely precipitate a renewed credit crunch. Then it is difficult to see how the British SME sector can play its crucial part in the export-led, private sector recovery on which all our hopes for economic growth are pinned.

Conservative backbench critics of the Irish bailout are consoled by their clear understanding that such assistance would not have been offered to Portugal, Belgium or Spain. Perhaps this faith will soon be put to the test.

If only the storm raging off the Irish coast were containable. The fear now must be that sovereign default elsewhere in Europe will destroy trust and confidence as it did during the collapse of September 2008. If so, this will have a profound psychological effect on global economic prospects for the years ahead.