Could England Be the Next Iceland?

Before you dismiss the headline as nutty, at least one respected macroeconomist and former central banker, and now chief economist of Citigroup is of the view that England is at risk of a currency crisis. He noted last November:

With the pound sterling dropping like a stone against most other currencies and credit default swap rates on long-term UK sovereign debt beginning to edge up, this is a good time to revisit a suggestion I made earlier on a number of occasions (e.g. here, here and here), that there is a non-trivial risk of the UK becoming the next Iceland.

The risk of a triple crisis – a banking crisis, a currency crisis and a sovereign debt default crisis – is always there for countries that are afflicted with the inconsistent quartet identified by Anne Sibert and myself in our work on Iceland: (1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity.

Gillian Tett provides an update on the UK’s indebtedness, and the picture is not pretty. Admittedly, gross debt is not one of Buiter’s signs of trouble, but it often translates into limited fiscal capacity. And England still has a large, internationally exposed banking sector. In fact, that is one reason to think the powers that be may not be bluffing at all when they seek to impose tougher rules on banks, and will accept their departure as a necessary consequence. England cannot afford to have an unconstrained banking sector. It cannot afford another crisis rescue operation. As General Pyrrhus famously said, “One more victory will undo me!”

From the Financial Times (hat tip reader Don B):

Which country experienced the biggest jump in debt, relative to gross domestic product, over the past decade?…if McKinsey consultants are to be believed, the real leverage giant – at least among the big western economies – is actually the UK. After crunching the data, McKinsey estimates that the gross level of British private and public debt is now 449 per cent of GDP – up from 350 per cent at the start of the decade.

And even excluding the liabilities of foreign banks based in the UK, the ratio still runs at 380 per cent – higher than any country except Japan (closely followed by Spain where debt has also spiralled dramatically, according to a McKinsey report issued today.*)

That is sobering stuff, particularly for UK voters. However, it also raises a much bigger point. In the middle of the last decade, it was often frustratingly difficult to get any data on leverage levels, since it was an issue on which precious few policymakers focused…

Now, of course, the world is radically different. But, as McKinsey points out, there is still surprisingly little known about the actual mechanics of “deleveraging”, compared with, say, all that research that has been conducted on financial crises. And so it has tried to plug this gap by both plotting the recent pattern of global leverage levels – and then setting it in a wider historical context, to show how deleveraging has (or has not) occurred before…

Nevertheless, some of the patterns in the report are fascinating – and valuable –precisely because they have often been ignored. Contrary to popular perception, for example, McKinsey points out that, by historical standards, most of the financial world was not crazily leveraged in the past decade. Instead, the crazy debt increase was focused on a small group of brokers, and global banks.

Moreover, alongside the (limited) rise in broker borrowing in the past decade, there was also a far more startling increase in “real economy” debt, particularly in the household and real estate sector.

Yves here. Tett is surprised? She shouldn’t be. Household debt grew rapidly in all countries experiencing housing bubbles. Although mortgage debt was obviously the main culprit, many (like the US, UK, and Australia) also featured impressive levels of unsecured borrowings, usually credit cards. Back to the story.

Since the crisis started, this “real economy” debt has declined a tiny bit, while financial sector leverage has fallen considerably. But since public debt has spiralled, gross leverage levels for most large nations have not fallen. And that, in turn, has a crucial implication: namely that, insofar as deleveraging is inevitable, much of it is still to come. From a historical perspective, this challenge is not entirely unprecedented. The UK and US have, after all, slashed vast debt burdens before during the last two centuries, and McKinsey has identified four dozen smaller deleveraging episodes around the world since 1950.

But while governments have sometimes softened this task before by creating rapid growth, often due to exports (via devaluation), or a peace dividend (after a war), those routes do not look offer an easy escape this time. Growth, in other words, could be tough to achieve. So that leaves three, unpalatable options, McKinsey suggests: outright default, inflation or belt-tightening.

McKinsey’s best guess – or hope – is that belt-tightening will predominate, and it consequently forecasts a grim climate of austerity for the next decade. It may be right. But to my mind, at least, it remains a very open bet whether western voters will accept austerity without a backlash; personally, I would thus put a higher emphasis on the other options too.

Either way, the real moral is that the task now facing the western governments is monumental. It is a pity that groups such as McKinsey were not producing these leverage charts three years ago. If so, the politicians might now not be in quite such a pickle, even – or especially – in the UK.

Yves here. I cannot imagine McKinsey doing this sort of work three years ago. McKinsey is in the business of dispensing what I have long called leading edge conventional wisdom. Nothing so far ahead of the curve as to be threatening.

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40 comments

  1. Ted K

    HOW could McKinsey have tracked this leverage on a chart 3 years ago??? Since a large portion of that debt was uncollateralized CDOs and CDS in an unregulated market, I would be curious to know how they could have tracked that accurately 3 years ago

      1. Jeremy Johnson

        There isn’t an “uncollateralized collateralized debt obligation (CDO). By definition a CDO is collateralized by something. Often time a CDO can best be described as a small bank. It has some equity, some subordinated debt and some senior debt and it uses that money to invest in loans.

        To your point though, there is lots of information on the the total market for CDOs. You can pretty easily find out how many outstanding CDOs of each type there are.

        1. Ted K

          Gee, thanks, I always wondered what that acronym meant……. You’re just jam-packed with info. Jeremy. Although I have a feeling your answer is about as good as Yves could have come up with, since she chose not to answer the question.

  2. Macstibs

    Indeed, despite all their protestations of departure, the bankers should consider this: if England can’t afford to backstop their risky behavior, who the hell can and will therefore welcome their unsavory and unsafe antics?

    Quite clearly, the answer is no one other than the dumb-ass Americans. China could afford to, but they wouldn’t tolerate this risk-shifting game for more than a year before some of the worst offenders were literally executed in the public square. Food for thought perhaps.

    1. Ted K

      Yes, it’s America’s fault Britain has so much arrogance, they were the last ones to jump to the EURO. Anything else you want to blame on us???

  3. Owe Jessen

    I would be very suprised if western politicians had the stomach for outright austerity programs or outright default – leaves inflation as a time-honoured way-out. The question remains, if they will be able to keep it under control – with 10% inflation over 10 years the real value of the debt will only be 38%.

    1. jake chase

      Hard to imagine inflation as a solution. Isn’t Britain import dependent? Sounds like a choice of austerity or austerity. Also, what’s the parallel to Iceland, which had very little soverign debt, which was the reason it could refuse to bail out its banks?

  4. DoctoRx

    The reports of a “grim” economy if true deleveraging occurs are uber-strange. When one actually reads them, one finds that “growth” (which is not always good) might be one percent less with deleveraging.

    Since, increasingly, financial gimmicks have been used to pump “growth”, the solution is to eliminate the gimmickry.

    A healing patient may or may not feel well from medicine or surgery, but the knowledge of improvement and a better prognosis leads to a happier person who can and will make plans for a brighter future. The same will occur if common sense reigns and we move to a saner, simpler financial system.

    It’s not just the debt. It’s all the derivatives, layers and layers of financial products, etc. It’s out of control and in the past decade has obviously net-net impeded true growth. How is it that with about a 20% larger population, rail shipments in America carry about the same volume of stuff as in the early 1990s, if all we had was a several-month storm from the Lehman/AIG messes? The problems run deeper, and McKinsey knows it.

    1. fresno dan

      “When one actually reads them, one finds that “growth” (which is not always good) might be one percent less with deleveraging.”
      My feelings exactly. My newspaper (Washington Post) had an article about the “New American Home” – some kind of show home built yearly. And because of financing, these gargantuan homes that cost 3.5 million were still being built. Except NOW, builders (who must be the last people on Earth to realize there are more houses than there needs to be) have defaulted, and the not completed thing will sell for 600K or such.
      My point being the same as yours – a lot of unsustainable pumping. Slow and steady wins the race.

  5. Jo

    ‘England’ doesn’t have a currency.

    Try ‘Britain’ or ‘UK’ in future.

    Hint: stop watching b&w 1950s war movies.

    1. Ted K

      Kind of pathetic, when years after the fact your leaders were the last ones to clue into the trend that the Euro would dominate, then you have to defend your country with semantics and personal attacks.

      Singing “Rule Brittania” only has that feeling at the pub my friend, no where else.

  6. Paulo

    Britain’s fiscal problem stems from its failure to control public expenditure during the good times. Gordon Brown more than doubled real spending on health and education but resisted Tony Blair’s plans to reform the public services. Much of the money has been wasted or spent on salary increases / staff increases. Today public employees enjoy comparatively better pay and very valuable “defined benefit” pensions (unlike private-sector employees).

    The govt was running a big deficit pre-crisis and the crisis has aggravated it greatly. (Britain is not a low-tax jurisdiction.)

    Worth also noting that Britain primarily bailed out deposit-taking institutions in Northern England and Scotland (Northern Rock, Bradford & Bingley, HBOS (govt forced Lloyds to buy it), RBS etc.). These banks got into trouble due to imprudent mortgage lending and were generally not bonus-payers or investment banks.

    The UK govt comprehensively failed in regulating the banks located in Labour heartlands. That’s why its banking system is in trouble.

  7. Siggy

    You could write a song about it: What the World needs now is Sovereign Debt Default.

    As to McKinsey, mainstream leading edge advice, lovely description. Or, do it yourself management by way of interviews that are used to spew back what the workforce already knows and that which the management does not deem to be relevant.

    If Britain is, indeed, on the verge of a currency default, that would be very bad news for the financial markets. Also, this mess will only be cleared when the financial rubbish is cleared away. If Britain were to repudiate all that debt that cannot be serviced we might begin to get somewhere.

  8. MyLessThanPrimeBeef

    About those 3 options for Engla…, sorry, Great Britain – default, inflation or belt tightening – I am thinking there could be a 4th one: become the 51st state.

    You know, mother country-daughter country reunion, that sort of thing.

    PS: It’s not that I am advocating it. I am just listing the possibilities. Actually, I prefer they become our colony. You know, the karma thing…

    1. Andrzej

      Karma thing? Let’s hope the Vietnamese, Iraqis, Afghans, Costa Ricans, Panamanians, Iranians, North Koreans, Venezuelans, Cubans, Yemeni et al don’t have the same idea.

      I mean, at the end of the day, making Americans pay taxes pales into significance if you going to talk about a goes around comes around foreign policy.

  9. MyLessThanPrimeBeef

    By the way, I had a dream the other day and I dreamed an eventual United States of America, Europe and Australia (USAEA) to counterbalance China one day….I don’t rememmber the details of the dream, but I think it was around the 22nd or 23rd century AD and was done fairly quickly over a dinner party attened by the CEOs of the two remainging corporations in the three continents. The one peculiar thing I recall is that each corporation had an East CEO, West CEO, North CEO and South CEO…kind of like the way Rome was governed at the end.

  10. MyLessThanPrimeBeef

    By the way, I had a dream the other day and I dreamed an eventual United States of America, Europe and Australia (USAEA) to counterbalance China one day….I don’t rememmber the details of the dream, but I think it was around the 22nd or 23rd century AD and was done fairly quickly over a dinner party attened by the CEOs of the two remainging corporations in the three continents. The one peculiar thing I recall is that each corporation had an East CEO, West CEO, North CEO and South CEO…kind of like the way Rome was governed at the end.

  11. joebek

    Not this round. If anything we are entering what the Austrians call the Katastrophen Hausse, usually translated as the “crack-up boom”. Seems to me to be a bit tame as a translation. We have become familiar with the term “catastrophic success” from reflection on the consequences of the early results of the war in Iraq so perhaps a more literal, “catastrophic boom” would resonate. I would suggest something more singular like the “boom to hell”. Looks like it has already started down in Texas. I dunno though. Maybe Bernanke, Summers and Geithner can pull it off. After all we can put a man on the moon. Or at least we once were able to.

  12. Claire

    ‘In fact, that is one reason to think the powers that be may not be bluffing at all when they seek to impose tougher rules on banks, and will accept their departure as a necessary consequence. England cannot afford to have an unconstrained banking sector. It cannot afford another crisis rescue operation. As General Pyrrhus famously said, “One more victory will undo me!” ‘

    I don’t think the British government is nearly that forward-looking, but I think the point is correct: Neither Britain nor most of the rest of the world can afford to deal with the aftermath of another rescue operation. It’s highly doubtful, when all is said and done, that they will be able to deal with the aftermath of this one.

  13. Blurtman

    On the positive side, belt tightening and fiscal austerity in the UK should result in a great new music scene.

  14. Blissex

    «McKinsey’s best guess – or hope – is that belt-tightening will predominate, and it consequently forecasts a grim climate of austerity for the next decade. It may be right. But to my mind, at least, it remains a very open bet whether western voters will accept austerity without a backlash; personally, I would thus put a higher emphasis on the other options too.»

    The key feature of the past 25 years, which Rove, Norquist and their imitators have both supported and taken advantage of, is that 70% of voters are middle aged or older, and own houses and stocks.

    What they want, and all they votes for, is to have large chunks of produced income and wealth redistributed to themselves via huge capital gains generated by asset price booms, at the expense of those with less assets than they do.

    That’s not all they want; they also want wages to go down, as they perceive themselves as rentier landlords, and worker wages as lifestyle costs. They are delighted by labor arbitrage in their favour when more immigrants and more imports make services like gardening and goods like electronics much cheaper at the same time their capital gains grow.

    Of course they haven’t thought about who really benefits from asset inflation and wage deflation, or the consequences, and balance of payment issues, but that’s because they have been entirely corrupted by their greed and pettyness, their politics being “F*CK YOU! I got mine!”.

    These people, especially as they become pensioners, will vote for belt-tightening (for others, of course) to protect their fixed incomes and the low interest rates that create asset price bubbles (for a while).

    No surprise that in the UK election campaign both main parties promise huge spending cuts and general belt tightenting for people suffering an earned income in order to keep wages and prices low and interest rates at asset price bubble levels.

    1. joebek

      It is certainly true that the rentier class will support policies that “promise” asset price inflation and, to a lesser extent, wage deflation. However, it is unlikely that these policies can deliver over the long term, more than a decade. Look at the Nikkei. It is still down nearly 80% from its 89 high. Eventually the rentier class will be bludgeoned into acceptance, even ecstatic enthusiasm, for statis with a bias to mild decline. This is why the Democrats prospects are actually pretty good for the foreseeable future. It turns out change we can believe in is change from a dynamic, turbulent, government (FED) subsided capitalism to a somnolent welfarism. Change you can sleep through. Eventually the dam will break but that is probably two or three decades away; unless China collapses.

    2. bob

      Great comments. Agree on the pensioners. I would like to see a survey of ‘teabaggers’ and see who of them were getting health care via the government. Veterans, government workers and teachers (or spouses) would be the biggest groups, I think.

      The segregation of pension plans in the NYS teachers retirement system comes to mind. All new teachers are now part of a separate retirement system, with reduced benefits, and bargaining power.

      http://www.wten.com/Global/story.asp?S=11790569

      Segregation of younger groups of people into ineffective bargaining groups is nothing new. 18 to vote, 21 to buy alcohol, 25 to get car insurance without paying an arm and a leg. Most of these changes were put into effect (or allowed to happen) by the so called boomers.

      How the older will be cared for is open to debate, but I don’t see how continuing this will gain them much sympathy.

  15. Ron C

    Wouldn’t England be considered to big to fail? I’ll bet U.S. taxpayers would be happy to bail them out.

  16. steve from virginia

    The over- under question of the day is not Indianapolis Colts/Baltimore Ravens but rather how many months before Willem Buiter is fired from Citi.

    I can hear his bosses now! “Where or where is the UP? Where is the ‘getting back to even’? How is blowing off England going to please the clientèle?”

    This is the new commentary horse race! Evans- Pritchard’s debt default horse is Japan, Buiter’s is Merrie Olde England. The default (repudiation, anyone?) horse race could be another betting angle. Send in the touts! I suspect Greece will belly- up before either Spain, Ireland (which has started to go austerity on us and might escape default), Dubai (again), Japan or China, which is my dark horse favorite.

    The lesson, of course, is that credit is a terrible substitute for petroleum and when you need crude you need it now and bad and will do anything to get it, including bankrupt half of your country’s businesses – which is ongoing in the US, btw.

    Each giant six wheel pickup truck or massive, bloated SUV is another failed business that employs fifty or more people. A dozen massive pickups/SUV’s equals one Haiti. My country bleeds unrecoverable energy right before my eyes! I can see catastrophe unfold in a parking lot in front of any Seven- Eleven.

    I keep thinking that one of these days one country, just one, out of desperate necessity will decide to cut energy consumption in half by rationing, junking all their cars and otherwise doing without at least half of current consumption … and their credit situation will instantly improve. They will ‘go local’, their currency won’t matter to the sheikhs, the employment rate will increase (as more tasks will require doing by human hands), there will be less carbon/environmental degradation, etc. etc. etc.

    Oh well, a stupid and unrealistic fantasy! Rather, the US will nuke Saudi Arabia’s major cities and steal its oil … that’s the reality that stares all of us in the face. The face of ‘Happy Motoring’ buzzing with ionizing radiation.

    Okay, you can send in the antidotes for the day now …

    1. dlr

      You left out Switzerland!

      (1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity.

  17. Rick

    I graduated from a Top Ten MBA program in the US in 2008. In spent a week in Cleveland attending the “McKinsey Leadership Focus” program, and, subsequently, interviewed with them for an associate (management consultant) position.

    I did not do well. I was reading Roubini’s blog at the time (late 2006), and was thus much more interested in what Roubini was saying than in the pablum I was learning at b-school. I also did not see the point in being able to hem and haw articulately using vague, quaint “analytical” models like the 4Ps, 5Cs, 7S (this one developed by McKinsey itself), just to be able to spit out an answer at the end of the “case” interview.

    Anyone who has been through a case interview, with McKinsey, Bain, BCG, or any of the others, knows that these companies couldn’t recognize a big picture issue if it bit them in the ass. Woe betide the CEO who relies on them for advice.

  18. froggy

    Just a correction: the view of Mr Buiter is not from last november as stated but from November 2008.

  19. Brick

    Could the UK be the next Iceland then the answer is probably maybe but not for many of the reasons mentioned here. For a start let me correct some possible miss conceptions about the housing bubble in the UK. House planning rules in the UK are quite strict and actually there were some financial standards in place in the UK for mortgages, with immigration from eastern Europe the supply of housing is in short supply unlike in the US where they may be surpluses in certain areas. This does not mean there was not a housing bubble just that generally your average home owner did not take part. Yes there was equity withdrawal but not on the same scale as in the US and again we had the house flippers. The area which really took of, was for in self certification of mortgages to the self employed and to the buy to let market. This led to an oversupply of city centre flats (condos) and the big players in the buy to let arena like northern rock going under. Since first time buyers still cannot get into the market I think there is still some froth in the UK housing market at the lower end, but who knows maybe we are heading down the French route where people mostly rent.
    What nobody has really talked about is local government and more particularly district council budgets. Many of these have big deficits, invested in the likes of Icelandic banks and lehman to get high yield and are currently in no mans land. I expect a backdoor bailout via money to build new schools police stations, hospitals and the like. Since the UK government has spent the last decade throwing money at this anyway somebody will eventually catch on that rebuilding the same school every year is probably not a useful way to employ capital. The bottom line is that the current government was applying a Keynesian stimulus even before the downturn. The current government will never be able to wean themselves of this.
    The other problems is the moral hazard associated with the safety net of social security. The other day I spoke to a relative who was pleased to have got a job. It was not high paying and she confessed that she would probably have to sell the house as a result, and was not looking forward to being worse off. You see she has 8 kids and the social security payouts worked out to much more than any wage she could earn. Self respect though has its own price and at the end of the day we all pay for the government largesse in the end.
    As for consumer leverage then I certainly think this was a factor and the problem was that certain US subsidiaries seemed to have warped the credit market in the UK such that the traditional UK banking system was left with no choice but to hibernate. Lots of people took on too much apparently cheap debt, but I have my suspicions that the leverage may not have been any worse that that applied in the US.
    The real crunch will come at election time, when quite possibly the UK gets a hung parliament. This will imply that the UK government is shackled in its ability to make difficult decisions and I would expect the ratings agencies to act in that circumstance. The UK has wasted its ability to stimulate the economy and the coffers are empty. Shush, just don’t tell anybody just yet.

  20. gelboak

    “..leading edge conventional wisdom” to describe McKinsey. I have liked your blog for a long time, but that has got to be one of your best and most memorable phrases, Yves.

    In a related not, here’s GE CEO Immelt in a Guardian interview:

    “We had McKinsey do a study in July 2007 and we asked them to say how long the global liquidity bubble will last and they came back and said forever, so it wasn’t like we didn’t ask the tough questions.”

    1. DH

      Agree 100%, gotta love the phrase. Also reading the above B-school’ers impression of McKinsey (with its 4P’s and 7S’s) I couldn’t agree more. These so-called “frameworks” are often nothing more than the generator of boxed-in conventional group-think. I would like to propose “model-driven myopia” as an apt description of their collective effect.

  21. Sid

    “leading edge conventional wisdom”

    Did not Tom Wolfe teach us that “it is no use being more than fifteen minutes ahead of the times?”

  22. Pat Donnelly

    All I get from accessing the refernce is:

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    I got to comment on this as I had posted the naked ref on another site who did not allow me to post the FT reference!

  23. John Davidson

    I bet the Scots, Welsh and Northern Irish are pleased to be left out of this doomer analysis. Simple things like getting the very basis of your analysis wrong – is it the UK or England you are talking about as they are very different entities? – makes me question the accuracy of the article as a whole.
    No wonder other coutries think we Americans are arrogant when you look at the title of this piece and then at some of the replies. Very sad.

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